The expectations hypothesis of the term structure and time-varying risk premia: a panel data approach

One implication of the expectations hypothesis is that the yield spread should forecast subsequent changes in the long yield. However, regression tests based on this specification strongly reject the expectations hypothesis. One explanation for this rejection is that these tests fail to allow for a time-varying risk premium that is correlated with this yield spread, leading to a bias in the estimated regression coefficients. This paper uses panel data in order to test the expectations hypothesis under the assumption that risk premia are time-varying but driven by a single factor. It is found that while the expectations hypothesis is still rejected, the bias in the estimated coefficient is very substantially reduced.