A Test of the Expectations Hypothesis of the Term Structure Using Cross-Section Data

Abstract

This paper tests the expectations hypothesis of the term structure using cross-section bond yield data. A long series of monthly cross-section regressions is estimated using zero coupon bond yields for maturities from two months to thirty-five years. The expectations hypothesis is tested using the time-series average of the estimated slope parameter in the cross-section regressions. To allow for maturity-specific, and possibly time-varying risk, the squared excess holding period return for each bond is used as a proxy for the risk premium and the regressions are estimated by instrumental variables. In strong contrast with existing evidence from time-series tests, it is found that the expectations hypothesis cannot be rejected, with estimated parameters close to their hypothesised values. The risk premium itself is significant only for the sub-sample of short maturity bonds.