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

Richard Harris

Applied Financial Economics, 2004, vol. 14, issue 2, 105-112

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.

Date: 2004
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DOI: 10.1080/0960310042000176371

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