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The Expectations Hypothesis explains stylized Fact 1.docx

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Zisimos Koustas

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The Expectations Hypothesis explains stylized Fact 1 (Short and long rates novae together) a) short rate rises are persistent b) if i1t↑ today, i1t+1,i1t+2ect↑ the average of expected future rates↑ iNt ↑ c) Therefore short and long rates more together It explains stylized Fact 2 (yield curves tend to have steep slope when short rates are low and downward slope when short rates are high) a) When short rates are low, they are expected to rise (regress) to their normal level, and the long rate (average of future short rates) will be well above today’s short rate. The yield curve will have a steep upward slope. b) When short rates are high, they will be expected to fall in the future, and the long rate will be below the current short rate. The yield curve will have a downward slope. It does not explain stylized Fact3 (the yield curve is usually upward sloping) In order to explain this fact we would have to argue that people almost always expect short rates to rise in the future. This is not a plausible argument. a) The segmented markets Theory Key Assumption: Bonds of different maturities are not substitutes at all. Implication: markets are completely segmented (zero substitutability among different maturities) the yield at each maturity is determined separately. The relative supplies of debt instruments play a central role in the determination of the shape of the yield curve. It explains Fact3 (the yield curve is usually upward sloping) people typically prefer short holding periods and thus have a higher price and a
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