ABSTRACT
This chapter explores the expectations hypothesis. The expectations hypothesis should really be called the expectations hypotheses— plural. The motivation for the present value form of the expectations hypothesis can be understood by considering standard investment theory. In an equilibrium economy consisting of only risk-neutral investors, the excess expected return on all assets, including zero-coupon bonds, must be zero. The analysis is kept purposely simple in order to facilitate understanding and to illustrate the ease in which one can reject both forms of the expectations hypothesis. An alternative joint non-parametric test rejects the unbiased forward rate form of the expectations hypothesis more definitively. The forward rate forecasting bias for all maturities increases with time-to-maturity. This could not occur by chance under the forecasting bias form of the expectations hypothesis, and it is consistent with the hypothesis that forward rates have an embedded risk premium that increases with time-to-maturity.
