The Information Content of the Term Structure of Interest

This paper presents the results of an alternative test of the rational expectations theory of the term structure of interest rates. The validity of the expectations hypothesis of term structure has also been examined by other researchers. While there is more often rejection of the expectations hypothesis, no other theory (data-consistent with the entire yield curve) provides empiricailly adequate expleination of this phenomenon. The study considers postwar U.S. pure discount (zero coupon) bond yields with various maturities, starting from one month throughout 60 months. Based on the ex-post formation of rational expectations, we quantify the expectations error and test the level of truth of the expectations hypothesis, that is, the strength of the departure of the yield curve from the expectations theory. The results suggest that a significant amount of information available at no cost to market agents is not incorporated in forming people's expectations.