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Testing the Expectations Hypothesis of the Term Structure Using Instrumental Variables

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  • Driffill, John
  • Psaradakis, Zacharias
  • Sola, Martin

Abstract

This paper demonstrates, by means of Monte Carlo experimentation, that tests of the expectations hypothesis of the term structure based on instrumental variables regressions of the change in the short rate on the relevant lagged yield spread are prone to severe over-rejection when the term premium is time-varying. In contrast, tests based on regressions of the yield spread on the first-difference of the short rate are found to reject at the correct rate in moderately sized samples. Copyright @ 1998 by John Wiley & Sons, Ltd. All rights reserved.

Suggested Citation

  • Driffill, John & Psaradakis, Zacharias & Sola, Martin, 1998. "Testing the Expectations Hypothesis of the Term Structure Using Instrumental Variables," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 3(4), pages 321-325, October.
    • Handle: RePEc:ijf:ijfiec:v:3:y:1998:i:4:p:321-25
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    Cited by:

    1. Meng-Fen Hsieh & Chien-Chiang Lee, 2010. "The Puzzle Between Banking Competition and Profitability can be Solved: International Evidence from Bank-Level Data," Journal of Financial Services Research, Springer;Western Finance Association, vol. 38(2), pages 135-157, December.
    2. Argyropoulos Efthymios & Tzavalis Elias, 2015. "Term spread regressions of the rational expectations hypothesis of the term structure allowing for risk premium effects," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 19(1), pages 49-70, February.
    3. Balcilar, Mehmet & Gupta, Rangan & Lee, Chien-Chiang & Olasehinde-Williams, Godwin, 2018. "The synergistic effect of insurance and banking sector activities on economic growth in Africa," Economic Systems, Elsevier, vol. 42(4), pages 637-648.
    4. Tzavalis, Elias, 2004. "The term premium and the puzzles of the expectations hypothesis of the term structure," Economic Modelling, Elsevier, vol. 21(1), pages 73-93, January.
    5. Argyropoulos, Efthymios & Tzavalis, Elias, 2015. "Real term structure forecasts of consumption growth," Journal of Empirical Finance, Elsevier, vol. 33(C), pages 208-222.
    6. Lee, Chien-Chiang & Hsieh, Meng-Fen, 2013. "The impact of bank capital on profitability and risk in Asian banking," Journal of International Money and Finance, Elsevier, vol. 32(C), pages 251-281.
    7. Smant, David / D.J.C., 2010. "Direct tests of the expectations theory of the term structure: Survey expectations, the term premium and coefficient biases," MPRA Paper 19815, University Library of Munich, Germany.
    8. Bredin, Don, 2001. "Alternative Tests of the Expectations Hypothesis of the Term Structure of Interest Rates," Research Technical Papers 2/RT/01, Central Bank of Ireland.

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