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A re-examination of expectation hypothesis with time varying term premium

Abstract Since the expectation hypothesis was proposed, scholars have done a lot of research on it. We can see the important role of expectation hypothesis in finance. This paper also studies the expectation hypothesis on the term structure of interest rates. Our analysis is built upon the time-varying term premium. Fully conforming to what conjectured by the classical expectation hypothesis, the slope of the yield curve, together with the time-varying and stochastic term premium, is found to be useful for predicting the evolution of the bond yields. We use partial least squares to extract the single predictor from macroeconomic variables and use macroeconomic factor to predict time-varying term premium. The results give the evidence to support the time-varying term premium and the expectation hypothesis.