Around and Around: The Expectations Hypothesis

Abstract

We show how to construct models of the term structure of interest rates in which the expectations hypothesis holds. McCulloch (1993) presents such a model, thereby contradicting an assertion by Cox, Ingersoll, and Ross (1981), but his example is Gaussian and falls outside the class of finite‐dimensional Markovian models. We generalize McCulloch's model in three ways: (i) We provide an arbitrage‐free characterization of the unbiased expectations hypothesis in terms of forward rates; (ii) we extend this characterization to a whole class of expectations hypotheses; and (iii) we show how to construct finite‐dimensional Markovian and non‐Gaussian examples.

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