Expectation hypothesis and term structure anomaly

• DOI: http://doi.org/10.1002/ijfe.1703
• Published date: 01 April 2019
• Date: 01 April 2019
• Author: Kai‐Min Huang,I‐Doun Kuo,Cathy Yi‐Hsuan Chen

RESEARCH ARTICLE

Expectation hypothesis and term structure anomaly

I‐Doun Kuo

1

| Cathy Yi‐Hsuan Chen

2

| Kai‐Min Huang

3

1

Department of Finance, Tunghai

University, Taichung, Taiwan

2

School of Business and Economics,

Humboldt‐Universität zu Berlin, Berlin,

Germany

3

Department of Statistics, Tunghai

University, Taichung, Taiwan

Correspondence

Kai‐Min Huang, Department of Statistics,

Tunghai University, No.1727, Sec. 4,

Taiwan Boulevard, Xitun District,

Taichung 40704, Taiwan.

Email: forwardceo@forwardhr.com.tw

JEL Classification: E43; G12, G14

Abstract

Campbell and Shiller (1991) find the presence of term structure anomaly, in

which the slope of the term structure predicts inconsistently to the change in

yield of longer term bonds over the life of shorter term bonds during

1952–1987. Focusing on the post Campbell and Shiller period, our findings sug-

gest that the anomaly is not only attributed to term premia but also relates to

expectation errors. We found that macroeconomic surprises and irrationality

from investors' behaviour are important determinants of time‐varying expecta-

tion errors. These factors are capable of explaining the rejection of the expecta-

tion hypothesis and the U.S. term structure anomaly in long‐term securities.

KEYWORDS

expectation hypothesis, investor sentiment, irrationality, term structure anomaly, term structure of

interest rates

1|INTRODUCTION

The expectation hypothesis (EH) of the term structure of

interest rates, one of the best known theories in financial

economics, postulates that the spread between long‐term

and short‐term interest rates is capable of explaining or

even predicting changes in interest rates. That is, a posi-

tive (negative) yield spread between long‐term and

short‐term interest rates predicts a rising (declining)

interest rates. Conventional EH theory regards the spread

as a forecast of changes in interest rates and applies it to

interpret shifts in the yield curve. Campbell and Shiller

(1991) use U.S. Treasury bill/bond rates ranging from 1‐

month rates to 10‐year rate in the period of 1952 and

1987 and find that prediction is opposite to the expecta-

tion theory of term structure of interest rates. This

phenomenon contradicts EH theory and hence is called

a“term structure anomaly”in this study.

Numerous studies investigated the causes of this term

structure anomaly. We summarize the literature here to

outline the potential determinants. The first links to the

time‐varying term premia (Jongen, Verschoor, & Wolff,

2011; Mankiw & Miron, 1986; Mankiw & Summers,

1984). Holding default‐free bonds with long‐term

maturitiesin one's portfolio may not be the sameas holding

short‐term default‐free bonds because the latter strategy

incurs uncertainty of return for the second bond. Even

when accounting for time‐varying term premia, prior stud-

ies still struggle with the presence of the U.S. anomaly.

Backus, Gregory, and Zin (1989) find that variations in

the risk premium are insufficient to explain related results,

and a similarclaim has been proposed by Froot andFrankel

(1989) in the forward exchange market. Froot (1989) finds

that the time‐varying term premia explanation is exclu-

sively plausible only for short‐term securities, but it plays

a minor role in instruments with longer durations.

Peso problem also contributes to the term structure

anomaly or the failure of EH. Peso problems relate to

the sample moments that do not coincide with the popu-

lation moments. Specially, this reflects the fact that the

Fed's policy innovations can induce economic agents to

revise their expectations, because the available informa-

tion set is different from that observed in the past. This

change, in turn, causes forecast errors of interest rates

in small samples (Bekaert & Hodrick, 2001; Ederington

& Huang, 1995; Lewis, 1989; Mankiw & Summers, 1984).

The last source arises from the agents who trade irra-

tionally and hence impact asset prices and returns. More

Received: 7 March 2018 Revised: 28 June 2018 Accepted: 10 September 2018

DOI: 10.1002/ijfe.1703

Int J Fin Econ. 2019;24:1017–1029. © 2018 John Wiley & Sons, Ltd.wileyonlinelibrary.com/journal/ijfe 1017