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New Hope for the Expectations Hypothesis of the Term Structure of Interest Rates

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  • Kenneth A. Froot

Abstract

Survey data on interest rate expectations are used to separate the forward interest rate into an expected future rate and a term premium. These components are used to test separately two competing alternative hypotheses in tests of the term structure: that the expectations hypothesis does not hold, and that expected future long rates over- or underreact. to changes in short rates. While the spread consistently fails to predict future interest rate changes, we find that the nature of this failure is different, for short versus long maturities. For short maturities, expected future rates are rational forecasts. The poor predictions of the spread can therefore be attributed to variation in term premia. For longer-term bonds, however, we are unable to reject the expectations theory, in that a steeper yield curve reflects a one-for-one increase in expected future long rates. Here the perverse predictions of the spread reflect investors' failure to raise sufficiently their expectations of future long rates when the short rate rises. We confirm earlier findings that bond rates underreact to short rate changes, but now this result cannot be attributed to the term premium.

Suggested Citation

  • Kenneth A. Froot, 1987. "New Hope for the Expectations Hypothesis of the Term Structure of Interest Rates," NBER Working Papers 2363, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:2363
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    Cited by:

    1. Sarno, Lucio & Thornton, Daniel L. & Valente, Giorgio, 2007. "The Empirical Failure of the Expectations Hypothesis of the Term Structure of Bond Yields," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 42(1), pages 81-100, March.
    2. Carol L. Osler, 1989. "Interest Rate Term Premiums and the Failure of the Speculative Efficiency Hypothesis: A Theoretical Investigation," NBER Working Papers 3060, National Bureau of Economic Research, Inc.
    3. Shiller, Robert J. & Huston McCulloch, J., 1990. "The term structure of interest rates," Handbook of Monetary Economics, in: B. M. Friedman & F. H. Hahn (ed.), Handbook of Monetary Economics, edition 1, volume 1, chapter 13, pages 627-722, Elsevier.
    4. Thornton, Daniel L., 2006. "Tests of the Expectations Hypothesis: Resolving the Campbell-Shiller Paradox," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(2), pages 511-542, March.
    5. Söderlind, Paul & Söderström, Ulf & Vredin, Anders, 2003. "Taylor Rules and the Predictability of Interest Rates," Working Paper Series 147, Sveriges Riksbank (Central Bank of Sweden).
    6. Kim, Don H. & Orphanides, Athanasios, 2012. "Term Structure Estimation with Survey Data on Interest Rate Forecasts," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 47(1), pages 241-272, February.
    7. Jongen, Ron & Verschoor, Willem F C & Wolff, Christian C, 2005. "Time Variation in Term Premia: International Evidence," CEPR Discussion Papers 4959, C.E.P.R. Discussion Papers.
    8. Ederington, Louis H. & Huang, Chao-Hsi, 1995. "Parameter uncertainty and the rational expectations model of the term structure," Journal of Banking & Finance, Elsevier, vol. 19(2), pages 207-223, May.
    9. Thornton, Daniel L., 2005. "Tests of the expectations hypothesis: Resolving the anomalies when the short-term rate is the federal funds rate," Journal of Banking & Finance, Elsevier, vol. 29(10), pages 2541-2556, October.
    10. Christophe Belhomme, 1992. "Prime de risque et effet ARCH," Revue Économique, Programme National Persée, vol. 43(1), pages 55-70.
    11. Seppala, Juha, 2004. "The term structure of real interest rates: theory and evidence from UK index-linked bonds," Journal of Monetary Economics, Elsevier, vol. 51(7), pages 1509-1549, October.
    12. Grahame Johnson, 2003. "Measuring Interest Rate Expectations in Canada," Staff Working Papers 03-26, Bank of Canada.
    13. Andreas Fischer, 1989. "Interpreting the Term Structure of Interest Rates Using Weekly Money Announcements," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 125(I), pages 43-53, March.
    14. Iichiro Uesugi & Guy M. Yamashiro, 2003. "On the Relationship Between the Very Short Forward and the Spot Interest Rate," Discussion papers 03013, Research Institute of Economy, Trade and Industry (RIETI).

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