Rational Expectations and the Term Structure of Interest Rates

Abstract

THIS PAPER REPORTS SOME TESTS of two important hypotheses about the behavior of the tenn structure of interest rates. The first hypothesis is the hypothesis, which states that forward rates of interest are forced into equality with the short rates that investors expect to prevail in subsequent periods. Ee second hypothesis is that the expectations of investors are rational in the sense of John F. Muth [22].1 By this we mean that investors' expectations are equivalent with the optimal forecasts of statistical theory for a certain specifiled class of statistical models. A convenient way to characterize a market that satisfiles both of these hypotheses is as an efficient market.2 While the filrst hypothesis has been purportedly subjected to a bewildering variety of empirical tests, it has only rarely3 been tested within a framework that requires maintaining that expectations incorporate available information efficiently, the second hypothesis. The criterion of acceptable empirical results has generally been that of plausibility, a criterion with unfortunately little discriminatory power.

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