The Expectations Hypothesis of the Term Structure and Time Varying Risk Premia: a Panel Data Approach.

The expectations hypothesis of the term structure of interest rates implies that the spread between short and long bond yields should forecast next period's change in the long yield. Regression based tests have systematically rejected the expectations hypothesis, with estimated coefficients far from their hypothesized values. One explanation of this rejection is that regression tests fail to account for time varying risk premia that are correlated with the spread, causing a downward bias in the estimated regression parameters. This paper uses panel data in order to test the expectations hypothesis in the presence of time varying risk premia.