Around and Around: The Expectations Hypothesis

We show how to construct models of the term structure of interest rates in which the expectations hypothesis holds. McCulloch (1993) presents such a model, thereby contradicting an assertion by Cox, Ingersoll, and Ross (1981), but his example is Gaussian and falls outside the class of finite-dimensional Markovian models. We generalize McCulloch's model in three ways: (i) We provide an arbitrage-free characterization of the unbiased expectations hypothesis in terms of forward rates; (ii) we extend this characterization to a whole class of expectations hypotheses; and (iii) we show how to construct finite-dimensional Markovian and non-Gaussian examples.     

A description of farmland investor expectations

We consider how best to characterize agricultural real estate market participants' expectation formation mechanism. The expectation formation mechanism links current agricultural policies to asset prices and tells us how current policies change expectations for future transfers. We examine behavior of real estate prices and returns using the present value model. We derive estimable equations incorporating two rival expectation formation mechanisms: rational and adaptive expectations. Assuming rational expectations, the present value model yields parameter estimates that imply the model should be rejected. Instead of rejecting the present value model while maintaining the rational expectations hypothesis, we let the data reveal which expectations hypothesis best fits the data. When we assume the rival hypothesis, the model yields parameter estimates that conform to adaptive expectations.     

Monetary Policy Uncertainty and the Response of the Yield Curve to Policy Shocks

This paper studies the nonlinear response of the term structure of interest rates to monetary policy shocks and presents a new stylized fact. We show that uncertainty about monetary policy changes the way the term structure responds to monetary policy. A policy tightening leads to a significantly smaller increase in long-term bond yields if policy uncertainty is high at the time of the shock. We also look at the decomposition of bond yields into expectations about future policy and the term premium. The weaker response of yields is driven by the fall in term premia, which fall more strongly if uncertainty about policy is high. Conditional on a monetary policy shock, higher uncertainty about monetary policy tends to make securities with longer maturities relatively more attractive to investors. As a consequence, investors demand even lower term premia. These findings are robust to the measurement of monetary policy uncertainty, the definition of the monetary policy shock, and to changing the model specification.     

Consumption risk and the cross-section of government bond returns

In this paper we provide a consumption-based explanation of risk in nominal US Treasury bond portfolios. We use a consumption-CAPM with Epstein–Zin–Weil recursive preferences. Our model introduces two sources of risk: uncertainty about current consumption (reflected in contemporaneous consumption growth) and uncertainty about prospects of consumption in a long run (reflected in innovations to expectations about future consumption growth). We use a novel approach to estimate pricing factors in our model: we employ a factor-augmented VAR model with common factors, extracted from a large panel of macroeconomic and financial data, as state variables. We find that the important source of risk in US bonds is related to uncertainty in prospects in future consumption and it induces a positive and significant risk premium. We find as well that covariance risk related to innovations in expectations about future consumption growth is greater for long term bond portfolios than for short term bond portfolios, which is consistent with a duration measure of risk and justifies why long term bonds require greater premium than short term bonds. Our model explains well the cross-sectional variation in average excess returns of bonds with different maturities over the period 1975–2011 and compares favorably with competing models.     

THE EXPECTATIONS HYPOTHESIS OF THE TERM STRUCTURE IN EUROCURRENCY MARKETS

This paper uses daily eurocurrency deposit rates for six currencies to extend previous research on the expectations hypothesis of the term structure. The reported results confirm earlier findings that the behavior of long term interest rates is perverse. For example, it is shown that in the case of five-year eurocurrency deposits denominated in US dollars, German marks and Swiss francs, the coefficient relating the excess holding period return to the yield spread between long and short term securities exceeds one, implying that long term rates tend to move in a direction opposite to the prediction of the expectations hypothesis. This study also employs a variety of techniques to examine the temporal stability of the coefficient in both the long and short maturity regressions used in testing the expectations hypothesis. While we do find instability, the nature of the parameter variation is markedly different from that found in foreign exchange markets when similar tests are employed.     

Managerial Incentives and Stock Price Manipulation

We present a rational expectations model of optimal executive compensation in a setting where managers are in a position to manipulate short‐term stock prices and the manipulation propensity is uncertain. We analyze the tradeoffs involved in conditioning pay on long‐ versus short‐term performance and show how manipulation, and investors' uncertainty about it, affects the equilibrium pay contract and the informativeness of prices. Firm and manager characteristics determine the optimal compensation scheme: the strength of incentives, the pay horizon, and the use of options. We consider how corporate governance and disclosure regulations can help create an environment that enables better contracting.     

Testing the expectations hypothesis when interest rates are near integrated

Nominal interest rates are unlikely to be generated by unit-root processes. Using data on short and long interest rates from eight developed and six emerging economies, we test the expectations hypothesis using cointegration methods under the assumption that interest rates are near integrated. If the null hypothesis of no cointegration is rejected, we then test whether the estimated cointegrating vector is consistent with that suggested by the expectations hypothesis. The results show support for cointegration in 10 of the 14 countries we consider, and the cointegrating vector is similar across countries. However, the parameters differ from those suggested by theory. We relate our findings to existing literature on the failure of the expectations hypothesis and to the role of term premia.     

Time-variation in term premia: International survey-based evidence

Using a large, previously unexplored data set of survey-based interest rate forecasts that covers a broad range of countries, this paper re-examines the expectations hypothesis of the term structure of interest rates. We find that survey-based interest rate forecasts outperform not only a random walk forecast, but also outperform forecasts from forward rates. When using these superior survey-based forecasts in a modified expectations hypothesis test, the expectations hypothesis is rejected for fewer countries, at lower significance levels, and has greater explanatory power than when using a traditional forward rates-based test. We furthermore document strong time-variation in the term premia, which is an important reason why the traditional expectations hypothesis test is rejected so frequently. This time-variation seems to arise from the changing attitudes towards risk among market participants and as a compensation for the change in liquidity in the term structure. Finally, we find that generalizing findings from earlier U.S. studies to other countries may lead to bias in the true economic relationships in these countries.     

Does the Failure of the Expectations Hypothesis Matter for Long‐Term Investors?

We solve the portfolio problem of a long‐run investor when the term structure is Gaussian and when the investor has access to nominal bonds and stock. We apply our method to a three‐factor model that captures the failure of the expectations hypothesis. We extend this model to account for time‐varying expected inflation, and estimate the model with both inflation and term structure data. The estimates imply that the bond portfolio of a long‐run investor looks very different from the portfolio of a mean‐variance optimizer. In particular, time‐varying term premia generate large hedging demands for long‐term bonds.     

Term Structure of Interest Rates with Regime Shifts

We develop a term structure model where the short interest rate and the market price of risks are subject to discrete regime shifts. Empirical evidence from efficient method of moments estimation provides considerable support for the regime shifts model. Standard models, which include affine specifications with up to three factors, are sharply rejected in the data. Our diagnostics show that only the regime shifts model can account for the well–documented violations of the expectations hypothesis, the observed conditional volatility, and the conditional correlation across yields. We find that regimes are intimately related to business cycles.     

Adaptive expectations, underparameterization and the Lucas critique

A striking implication of the replacement of adaptive expectations by rational expectations was the “Lucas critique,” which showed that expectation parameters, and endogenous variable dynamics, depend on policy parameters. We consider this issue from the vantage point of bounded rationality, where for transparency we model bounded rationality by means of simple adaptive expectations. We show that for a range of processes, monetary policy remains subject to the Lucas critique. However, there are also regimes in which the expectation parameter is locally invariant and the Lucas critique does not apply.     

Expectations Models of Asset Prices: A Survey of Theory

This paper identifies restrictions on preferences under which various classes of “expectations” theories of asset prices—i.e., uncertainty models of asset prices which coincide with the corresponding certainty theory except that expected future prices replace actual future prices—are valid. Major classes of expectations models surveyed are martingale models, the expectations hypothesis of the term structure of interest rates, and models of exhaustible resources and futures markets. In each case the required restriction is related to the assumptiono f risk—neutrality, but the precise nature of the required restriction is shown to differ significantly among the various classes of expectations theories.     

Parameter risk in time-series mortality forecasts

The projection of mortality rates is an essential part of valuing liabilities in life insurance portfolios and pension schemes. An important tool for risk management and solvency purposes is a stochastic projection model. We show that ARIMA models can be better representations of mortality time-series than simple random-walk models. We also consider the issue of parameter risk in time-series models from the point of view of an insurer using them for regulatory risk reporting – formulae are given for decomposing overall risk into undiversifiable trend risk (parameter uncertainty) and diversifiable volatility. Particular attention is given to the contrasts in how academic researchers might view these models and how insurance regulators and practitioners in life offices might use them. Using a bootstrap method we find that, while certain kinds of parameter risk are negligible, others are too material to ignore. We also find that an objective model selection criterion, such as goodness of fit to past data, can result in the selection of a model with unstable parameter values. While this aspect of the model is superficially undesirable, it also leads to slightly higher capital requirements and thus makes the model of keen interest to regulators. Our conclusions have relevance to insurers using value-at-risk capital assessments in the European Union under Solvency II, but also territories using conditional tail expectations such as Australia, Canada and Switzerland.     

The term structure of commercial paper rates

This paper tests a generalized version of the expectations hypothesis in the market for commercial paper. Our main data set, which is new to the literature, consists of daily yield indexes constructed from the market yields for nearly all commercial paper issued by US corporations between 1998 and 2004. We show that term premia for commercial paper often rise dramatically at year-end. However, once we control for these year-end effects, we find considerable support for the generalized expectations hypothesis in the market for commercial paper.     

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

Survey data on interest rate expectations permit separate testing of the two alternative hypotheses in traditional term structure tests: that the expectations hypothesis fails, and that expected future interest rates are ex post inefficient forecasts. We find that the source of the spread's poor predictions of future interest rates varies with maturity. At short maturities the expectations hypothesis fails. At long maturities, however, changes in the yield curve reflect changes in expected future rates one-for-one, an implication of the expectations hypothesis. This result confirms earlier findings that long rates underreact to short rates, but now it cannot be attributed to term premia.     

A structural decomposition of the US yield curve

By expanding the macro part of macro-finance models, historical fluctuations in US bond yields turn out to be largely consistent with the rational expectations hypothesis. We estimate a medium-scale macro-finance DSGE model of the term structure to establish this. Our finding contrasts with existing macro-finance models and suggests that their—small-scale or non-structural—perspective on the macroeconomy mutes expectations, thereby underestimating the expectations hypothesis’ potential. Out-of-sample forecasts are competitive with more flexible term structure models. Given the empirical validation, we interpret various episodes through the lens of the model and investigate which structural shocks cause the yield curve to contain information about future growth.     

Does culture influence IPO underpricing?

This paper examines how cultural differences influence cross-sectional variation in IPO underpricing across 39 countries. We conjecture that cultural difference across geographic boundaries will influence the acceptance of and the expectations for IPO underpricing. Cross-sectional differences in culture are measured using Hofstede's six cultural dimensions. Our analysis shows that high power distance and high long term orientation are significantly associated with higher IPO underpricing. We also show that underpricing is significantly lower in countries characterized by high uncertainty avoidance. When the model is expanded to include legal origin, market based and corporate governance variables, the three cultural factors remain significant. Our findings provide further evidence that culture impacts capital market returns. Overall, our finding that culture impacts IPO underpricing, suggests important implications for policy makers and investors.     

Inflation risk premia and the expectations hypothesis

We study the properties of the nominal and real risk premia of the term structure of interest rates. We develop and solve the bond pricing implications of a structural monetary version of a real business cycle model, with taxes and endogenous monetary policy. We show the relation of this model with the class of essentially affine models that incorporate an endogenous state-dependent market price of risk. We characterize and estimate the inflation risk premium and find that over the last 40 years the ten-year inflation risk premium has been has averaged 70 basis points. It is time-varying, ranging from 20 to 140 basis points over the business cycle and its term structure is sharply upward sloping. The inflation risk premium explains 23% (42%) of the time variation in the five (ten)-year forward risk premium and it plays an important role in help explain deviations from the expectations hypothesis of interest rates.     

Measuring Inflation Expectations Uncertainty Using High‐Frequency Data

Inflation expectations play a key role in determining future economic outcomes. The associated uncertainty provides a direct gauge of how well‐anchored the inflation expectations are. We construct a model‐based measure of inflation expectations uncertainty by augmenting a standard unobserved components model of inflation with information from noisy and possibly biased measures of inflation expectations obtained from financial markets. This new model‐based measure of inflation expectations uncertainty is more accurately estimated and can provide valuable information for policymakers. Using U.S. data, we find significant changes in inflation expectations uncertainty during the Great Recession.     

Expected future earnings,taxation, and university enrollment

Taxation changes the expectations of prospective university students about their future level and uncertainty of after-tax income. To estimate the impact of taxes on university enrollment, we estimate a structural microeconometric model, in which a high-school graduate decides to enter university studies if expected lifetime utility from this choice is greater than that anticipated from starting to work right away. We estimate the ex-ante future paths of the expectation and variance of after-tax income for German high-school graduates, accounting for nonrandom selection. The enrollment model takes into account university dropout and unemployment risks. Consistently with expectations, the estimation results indicate that higher expected returns to a tertiary education increase the probability of university enrollment, whereas higher uncertainty among graduates decreases enrollment rates. A simulation based on the estimated model indicates that a revenue-neutral, flat-rate tax reform with an unchanged basic tax allowance would increase enrollment rates for men in Germany.