Expectations and the Term Structure of Interest Rate

Abstract:

This paper examines how investors' subjective expectations shape the term structure of interest rates. Rather than imposing rational expectations, we allow investors to hold arbitrary (and heterogenous) beliefs about future interest rates. We derive the relationships that expected and realized interest rates must satisfy under various assumptions on investors' expectations and develop regression-based tests for two key hypotheses: (i) that bond risk premia are constant, and (ii) that investors understand the structural relationships linking short- and long-term interest rates. Empirically, we find that short-term bonds do not exhibit time-varying risk premia, and market participants' expectations of different interest rates are not consistent with one another.