Estimation of the specification error in the expectations theory of the term structure

Paul Johnson

Applied Economics, 1997, vol. 29, issue 9, 1239-1247

Abstract: This paper asks, 'how false is the expectations theory of the term structure?'. Most previous work has asked, 'is the expectations theory true?' and finds that it is not. The goal here is to gauge the economic importance of these answers in the negative by estimating the specification error in the expectations theory. The variance of the estimated specification error (suitably normalized) provides a metric for assessing the validity of the model. I find that, while the expectations theory can be rejected, the importance of the rejection is much less than that implied by previous studies, so that the theory may still be a useful tool for understanding the relationships between interest rates at different maturities.

Date: 1997
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DOI: 10.1080/00036849700000014

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