The rational expectations hypothesis and the cross-section of bond yields

Abstract

In the context of the bond market, empirical tests of the rational expectations hypothesis (REH) have without exception been tests of the time-series properties of interest rates. However, the REH also imposes restrictions on the cross-section of bond yields at each point in time. This study tests these restrictions using the Fama and MacBeth repeated cross-section regression procedure. Specifically, a long series of monthly cross-section regressions is estimated using zero coupon bond yield data for maturities from two months to thirty-five years. The REH is tested using the time-series average of the estimated slope parameter in the cross-section regressions. The maturity-specific risk premium is proxied by the time-series volatility of excess returns for each bond maturity. Time-variation in the risk premium is allowed for through time-variation in the volatility of excess returns, and in the market price of risk. While the risk premium proxy is significant in explaining the cross-section of excess returns, the REH is very strongly rejected.

Acknowledgements

I am grateful to George Bulkley, Kaddour Hadri and Elias Tzavalis, and to seminar participants at the University of Auckland, the University of Otago, the University of Strathclyde, the University of Waikato, Victoria University of Wellington, the Reserve Bank of New Zealand, and ESAM99, Sydney, for their useful comments and suggestions.

Notes

¹ See, for instance, Shiller (1979), Shiller et al. (1983), Campbell and Shiller (1984), Mankiw and Summers (1984), Mankiw (1986), Campbell and Shiller (1991) and Campbell (1995).