The expectations hypothesis: New hope or illusory support?

Recent studies of the expectations hypothesis of the term structure (EHTS) find evidence in favor of the EHTS using post 1980s US data. This has been attributed to the relative macro stability of this period and greater market efficiency. Using a panel of forecasts for 3-month interest rates for ten countries we test separately for EHTS and rational expectations. Assuming rational expectations holds we find support for the EHTS is illusory due to an off-setting time-varying term premia and non-rational expectations. Previous forecast-based studies suggest biased expectations tend to reinforce the effect of a time varying term premium. This change can be understood in the context of Fama’s (2006) argument that markets tend to underestimate future spot rates during periods of long-run increases and overestimate during declines.     

Macroeconomic Sources of Risk in the Term Structure

We develop a new way of modeling time variation in term premia, based on the stochastic discount factor model of asset pricing. The joint distribution of excess U.S. bond returns of different maturity and the observable fundamental macroeconomic factors is modeled using multivariate GARCH with conditional covariances in the mean to capture the term premia. By testing the assumption of no arbitrage we derive a specification test of our model. We estimate the contribution made to the term premia at different maturities through real and nominal sources of risk. From the estimated term premia we recover the term structure of interest rates and examine how it varies through time. Finally, we examine whether the reported failures of the rational expectations hypothesis can be attributed to an omitted time-varying term premium.     

Do forecast errors or term premia really make the difference between long and short rates?

Forward rates in the term structure of interest contain predictions of future spot rates plus (possibly) term premia. Realized spot rates contain predicted spot rates plus forecast errors. Under rational expectations forecast errors are not predictable. By forecasting spot rates using publicly available information, bounds on the variation of forecast errors, and term premia are obtained. For one-month treasury bill rates, one to two thirds of the variation in the difference between forward rates and realized spot rates is due to variation in term premia.     

Rational Expectations and Risk Premia in Forward Markets: Primary Metals at the London Metals Exchange

This paper tests whether forward prices equal the traders' expectations of the future spot prices at maturity, under two different models of expectations formation: full information rational expectations and incomplete information mechanical forecasting rule. The tests are performed, over the period January 1970 through September 1980, on the forward markets for the primary metals—copper, tin, lead, and zinc-traded in the London Metals Exchange. We find evidence consistent with the existence of time varying risk premia.     

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.     

Using Survey Data of Inflation Expectations in the Estimation of Learning and Rational Expectations Models

Does survey data contain useful information for estimating macroeconomic models? We address this question by using survey data of inflation expectations to estimate the New Keynesian model by Smets and Wouters ( 2007 ) and compare its performance under rational expectations and adaptive learning. The survey information serves as an additional moment restriction and helps us to determine the learning agents' forecasting model for inflation. Adaptive learning fares similarly to rational expectations in fitting macro data, but clearly outperforms rational expectations in fitting macro and survey data simultaneously. In other words, survey data contain additional information that is not present in the macro data alone.     

Information in the Term Structure of Yield Curve Volatility

Using a novel no‐arbitrage model and extensive second‐moment data, we decompose conditional volatility of U.S. Treasury yields into volatilities of short‐rate expectations and term premia. Short‐rate expectations become more volatile than premia before recessions and during asset market distress. Correlation between shocks to premia and shocks to short‐rate expectations is close to zero on average and varies with the monetary policy stance. While Treasuries are nearly unexposed to variance shocks, investors pay a premium for hedging variance risk with derivatives. We illustrate the dynamics of the yield volatility components during and after the financial crisis.     

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.     

An Anatomy of Commodity Futures Risk Premia

We identify two types of risk premia in commodity futures returns: spot premia related to the risk in the underlying commodity, and term premia related to changes in the basis. Sorting on forecasting variables such as the futures basis, return momentum, volatility, inflation, hedging pressure, and liquidity results in sizable spot premia between 5% and 14% per annum and term premia between 1% and 3% per annum. We show that a single factor, the high‐minus‐low portfolio from basis sorts, explains the cross‐section of spot premia. Two additional basis factors are needed to explain the term premia.     

Is the foreign exchange market ‘risky’? Some new survey-based results

In this paper we examine the evidence in favour of time-varying risk premia for four foreign exchange markets. The main novelty in our work is that we use survey-based expectations data to generate risk premia, rather than exploiting the rational expectations assumption. In contrast to the perceived wisdom on the existence of a foreign exchange risk premium, we present positive evidence for the view that risk is an important variable in foreign exchange markets.     

Taylor rules and the term structure

The expectations model of the term structure has been subjected to numerous empirical tests and almost invariably rejected, with the failure generally attributed to systematic expectations errors or to shifts in risk premia. Rules for monetary policy designed along the lines of Taylor [1993. Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy 39, 195-214] specify that the central bank adjusts short-term yields in response to deviations of inflation and output gaps from target level. Such rules give a good empirical account of the behavior of the short-term interest rate. Combining the Taylor rule and expectations theory, it is possible to generate—along lines pioneered by Campbell and Shiller [1987. Cointegration and tests of present value models. Journal of Political Economy 95, 1062-1088]—a series of theoretical long-term interest rates. When such theoretical rates are calculated for the US over 1980-2004, considerable support for the expectations theory emerges.     

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.     

The determinants of bond call premia: A signalling approach

A signalling model is presented that provides an additional explanation for the determination of call premia on corporate bonds. It is shown that firms may signal their exclusive information about their probability of default by the choice of their call premia. Stockholders of safer firms (i.e., those that have a lower probability of bankruptcy) have a higher incentive for providing a low call premium. This occurs because the call option will be valuable only if the firm survives by the first call date. This event, however, is more likely for the safer firm. The safer firm will therefore be more willing to sacrifice some current revenues (or equivalently, to provide a higher coupon than it would otherwise have to pay in order to sell the bond at par) by determining a lower call premium. The model therefore predicts a negative correlation between safety and call premia, a correlation that has been empirically confirmed by Fischer, Heinkel, and Zechner (1989). This correlation provides support to the signalling theory vis-à-vis the alternative explanation of taxes determining the call premia. Another contribution of this model is that it ties the call premium decision with expectations of future interest rates. Such expectations are considered important by practitioners, but were rarely considered in previous research.     

Stochastic cash flow constraints and the term structure of interest

This paper attempts to provide a theoretical foundation for liquidity premia to be found in the term structure of interest rates. These premia arise from the borrowers' future availability of cash and from the lenders' future need for cash. In addition a third category of investors are active on the market: speculators who have no cash constraint and take positions on the basis of their expectations of future spot rates only. The interaction between these three groups yields an equilibrium term structure which is tested empirically; the test produces estimates of the relative weights of the groups in the determination of liquidity premia. Analysis of these weights indicates that there exists some market segmentation between bonds of different maturities.     

Stock Market Efficiency and the Federal Budget Deficit: Another Anomaly?

This paper investigates the efficiency of the U.S. stock market as it pertains to a number of major macrofinance variables that theory and empirical evidence suggest are important in rational stock pricing decisions. A multivariate vector autoregressive analysis is used to draw efficiency inferences. The estimated factor pricings are consistent with theory and previous empirical research. In addition, these results indicate that the stock market may be inefficient with respect to the federal budget deficit variable. Similar apparent inefficiency evidence is obtained for the term structure and risk premium variables. The authors cannot reject the efficiency hypothesis for industrial production, inflation, and base money. Using indirect causality tests, the authors find plausible intermediate information linkages connecting variables in the system. The term structure and risk premia variables consistently appear important as intermediate conduits through which information about other factors impact stock returns.     

Time-varying term premium in T-bill futures rate and the expectations hypothesis

This paper examines time-varying term premium in the T-bill futures rate to determine its significance for the expectations hypothesis (EH). Similar to previous studies on the T-bill forward rates, our data reject the joint hypothesis of the EH and the rational expectations hypothesis (RE). Under the assumption of zero rational expectational error, we find a substantial variation of term premium in the futures rate over time. Furthermore, the lower bound of the expected term premium variance is significantly positive when the rational expectational error is allowed to be nonzero. These findings are inconsistent with the EH. In addition, a relatively high ratio of the lower bound of the expected term premium variance to the prediction error variance implies that the poor predictive power of the futures rate should not be attributed mainly to the market's rational expectational errors.     

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.     

TIME-VARYING TERM PREMIA AND THE BEHAVIOR OF FORWARD INTEREST RATE PREDICTION ERRORS

In this paper I examine the time-varying expected term premium argument for the failure of the expectations hypothesis of the term structure of U.S. interest rates. Using an unobserved components model to estimate expected term premia from March 1951 to January 1991, I find considerable variation in estimated premia and significant persistence in their volatility over time.     

Why do firm fundamentals predict returns? Evidence from short selling activity

This study uses short selling activity to test whether the relation between fundamentals and future returns is due to rational pricing or mispricing. We find that short sellers target firms with fundamental performance below market expectations. We also show that short selling activity reduces the return predictability of fundamentals by speeding up the price adjustments to negative fundamental signals. To further investigate whether the returns earned by short sellers reflect rational risk premia or mispricing, we exploit a natural experiment, namely Regulation of SHO, which creates exogenous shocks to short selling by temporarily relaxing short-sale constraints. Evidence from the experiment confirms that the superior returns to short sellers result from exploiting overpricing. Overall, our study suggests that the return predictability of fundamentals reflects mispricing rather than rational risk premia.     

The term structure of real interest rates: theory and evidence from UK index-linked bonds

This paper studies the behavior of the default-risk-free real term structure and term premia in two general equilibrium endowment economies with complete markets but without money. In the first economy there are no frictions as in Lucas (Econometrica 46 (1978) 1429) and in the second risk-sharing is limited by the risk of default as in Alvarez and Jermann (Econometrica 68 (2000) 775; Rev. Financial Studies 14 (2001) 1117). Both models are solved numerically, calibrated to UK aggregate and household data, and the predictions are compared to data on real interest rates constructed from the UK index-linked data. While both models produce time-varying risk or term premia, only the model with limited risk-sharing can generate enough variation in the term premia to account for the rejections of expectations hypothesis.