Economics Webinar - Term Structure of Expectations and Expectations of Term Structures

According to the expectations hypothesis (EH) of the term structure of interest rates, yields on long-term bonds are determined by the bond market’s forecast of the short-term interest rates. Common empirical tests of EH proxy the expectations of short rates by their realizations, thus effectively jointly testing EH and rational expectations (RE) hypothesis. In this paper, we test EH under market participants’ subjective expectations. To this end, we develop a novel method to extract the entire term structure of expectations from survey data. We find that the yields implied by EH under subjective expectations closely match yield data, indicating that time-varying risk premiums are smaller than what is implied by imposing RE.