Expectations, the Term Structure of Interest Rates, and Recent British Experience

Abstract

Recently, confidence in the Expectations Hypothesis, which states that the shape of the structure of interest rates is determined by the actions of speculators in such a way that long-term and short-term securities are good substitutes for one another, has been weakened with reference to the British experience.2 These contradictions, both empirical and theoretical, have even cast doubt on earlier test results obtained by David Meiselman on the American data.3 In this article an alternative set of findings using the British data will be presented. These findings are broadly consistent with the results Meiselman obtained; they support the Expectations Hypothesis in a modified version-modified, that is, to account for hedging effects. In order to effect a careful test of the various hypotheses concerning the determination of relative interest rates, this article will discuss various other matters. In the first place, the theory of the term structure of interest rates is reorganized in a way designed to clarify matters often discussed in the literature; one of the results is a more convenient derivation of the Hicks formula for forward interest rates. In the second place, an improved technique (that of multiple regression) for constructing yield curves is described and utilized; this technique offers, among other advantages, a method whereby extraneous factors can be appraised and, if necessary, controlled. Lastly, some reference is made to matters of relevance to recent discussion of British monetary policy; particular emphasis is placed on the role of the British Monetary Authority with respect to the term structure of interest rates.