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.
Document Type: Research Article
Affiliations: School of Business and Economics University of Exeter Exeter EX4 4PU UK, Email: R.D.F.Harris@exeter.ac.uk
Publication date: January 15, 2004