Working Paper

On biases in tests of the expectations hypothesis of the term structure of interest rates

Abstract: We document extreme bias and dispersion in the small sample distributions of five standard regression tests of the expectations hypothesis of the term structure of interest rates. These biases derive from the extreme persistence in short interest rates. We derive approximate analytic expressions for these biases, and we characterize the small-sample distributions of these test statistics under a simple first-order autoregressive data generating process for the short rate. The biases are also present when the short rate is modeled with a more realistic regime-switching process. The differences between the small-sample distributions of test statistics and the asymptotic distributions partially reconcile the different inferences drawn when alternative tests are used to evaluate the expectations hypothesis. In general, the test statistics reject the expectations hypothesis more strongly and uniformly when they are evaluated using the small-sample distributions, as compared to the asymptotic distributions.

Keywords: Rational expectations (Economic theory); Interest rates;

Bibliographic Information

Provider: Federal Reserve Bank of Chicago

Part of Series: Working Paper Series, Issues in Financial Regulation

Publication Date: 1996

Number: WP-96-3