Single Equation Models, Co-Integration and the Expectations Hypothesis of the Term Structure of Interest Rates

Abstract

The purpose of this paper is twofold. First, by focusing on Single Equation and VECM techniques commonly employed to test for the Expectations Hypothesis of the Term Structure of interest rates (EHTS), it sheds light on the conditions - in terms of the dierent classes of stochastic processes of the spot and forward rates - that must hold for the EHTS to be valid. In doing so, the existing linkage between the two strands of literature is highlighted. Second, by using kalman lter and maximum likelihood, estimates of a permanent-transitory components model for spot and forward interest rates are carried out. The simple parametric model helps discern the relative contributions of both departures from rational expectation and time varying term premium to the invalidation of the EHTS. Departures from rational expectations turn out to have negligible impact on the rejection of the EHTS. Estimates of the time varying term premia for the short-end of the term structure spectrum are persistent and reasonable in magnitude, and exhibit sign uctuations.