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Tests of the Expectations Hypothesis of the Term Structure in a Model with Bayesian Learning

Author

Listed:
  • Bulkley, George
  • Harris, Richard
  • Weller, Paul

Abstract

Evidence that the term structure of interest rates does not satisfy the expectations hypothesis has been reported in a number of papers. However the nature and degree of this rejection is very sensitive to the exact specification of the tests. In this paper, we identify a source of small sample bias that is consistent with this empirical finding. The direction of the bias which we uncover implies that the expections hypothesis is more likely to be true than asymptotic test statistics would suggest. In financial markets, agents often receive information about the future in a form that cannot be explicityly incorporated in an econometric model. We formalise this idea by assuming that agenst supplement forecasts of the short yield obtained from the econometric model with noisy signals of the error term of the model. Using simulation experiments, we demonstrate that the bias is much more pronounced in the specification which has the more decisive rejection of the expectations hypothesis.

Suggested Citation

  • Bulkley, George & Harris, Richard & Weller, Paul, 1997. "Tests of the Expectations Hypothesis of the Term Structure in a Model with Bayesian Learning," Discussion Papers 9706, Exeter University, Department of Economics.
  • Handle: RePEc:exe:wpaper:9706
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    Cited by:

    1. Richard Harris, 2004. "The rational expectations hypothesis and the cross-section of bond yields," Applied Financial Economics, Taylor & Francis Journals, vol. 14(2), pages 105-112.

    More about this item

    Keywords

    Term Structure of Interest Rates; Small Sample Bias; Rational Expectations;

    JEL classification:

    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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