The Expectation Hypothesis of the Term Structure of Very Short-Term Rates: Statistical Tests and Economic Value

Abstract

This paper re-examines the validity of the Expectation Hypothesis (EH) of the term structure of US repo rates ranging in maturity from overnight to three months. We extend the work of Longstaff (2000) in two directions: (i) we implement statistical tests designed to increase test power in this context; (ii) we assess the economic value of departures from the EH based on criteria of profitability and economic significance. The EH is rejected throughout the term structure examined on the basis of the statistical tests. The results of our economic analysis are less uniform and more favorable to the EH, suggesting that the statistical rejections of the EH are not economically significant for rates with maturities of one month and longer.

Keywords: Expectation Hypothesis, Term Structure of Interest Rates, Vector Autoregression, Economic Value

JEL Classification: G10, E43