The term structure with macro factors, expectations hypothesis and regime shift

This paper shows that the expectations hypothesis (EH) of the term structure of interest rates is defensible despite the robust evidence on the predictability of excess bond returns. This is achieved through the introduction of regime-dependent heteroscedasticity into the discrete Vasicek model. The empirical purpose of this paper is to reexamine the adequacy of the EH. The restrictions implied by the EH are derived in the framework of regime switching macro-…nance model. The recursive tests provide evidence in favor of the EH. The results may suggest that time-varying risk premiums are second-order e¤ects of yield dynamics. Furthermore, two regimes are found to be intimately related to the Fed operating procedure shift in addition to usual business cycles.