A Test of the Rational Expectations Model of the Term Structure of Interest Rates

Abstract

Most tests of the rational expectations hypothesis have been

rejected. The purpose of this paper is to characterize the

aspects of the rational expectations model of the term structure

which contribute to the rejection, rather than to merely provide

testing statistics. One of the important characterizations I

found is that the long term rate reacts rationally with respect

to the unexpected movement of the short term rate irrespective

of whether this movement is temporary or permanent over all of

the studied subperiods, including 1890-1913. Secondly, the innovation

to the variable term premium is orthogonal to the unexpected

movement of the short term rate. Lastly, the rational

expectations model does not hold over the long run movements,

but does over the short run movements.