Why random walk models of the term structure are hard to reject

Tests of random walk models of the term structure generally fail to reject the null hypothesis, whereas direct tests of the fair game-efficient markets (FGEM) hypothesis generally reject the null. Random walk tests can be interpreted as FGEM tests that add measurement errors to the forward-rate revisions used in direct tests. Our empirical application is consistent with the literature; direct tests strongly reject the null, but random walk tests do not, despite using the same data and numbers of observations. The random walk measurement error is shown to reduce local asymptotic test power, which may explain this empirical puzzle.

[1]  Michael J. Hamburger,et al.  The Expectations Hypothesis and the Efficiency of the Treasury Bill Market , 1975 .

[2]  C. Granger,et al.  Spectral Analysis of the Term Structure of Interest Rates , 1968 .

[3]  T. Sargent.  A note on maximum likelihood estimation of the rational expectations model of the term structure , 1978 .

[4]  Thomas J. Sargent,et al.  Rational Expectations and the Term Structure of Interest Rates , 1972 .

[5]  H. Thompson,et al.  TIME SERIES ANALYSIS OF INTEREST RATES: SOME ADDITIONAL EVIDENCE , 1978 .

[6]  L. Hansen,et al.  Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis , 1980, Journal of Political Economy.

[7]  E. Fama.  EFFICIENT CAPITAL MARKETS: A REVIEW OF THEORY AND EMPIRICAL WORK* , 1970 .

[8]  Chris Chatfield,et al.  Introduction to Statistical Time Series. , 1976 .

[9]  R. Engle.  Wald, likelihood ratio, and Lagrange multiplier tests in econometrics , 1984 .

[10]  Dennis E. Logue,et al.  Foundations of Finance. , 1977 .

[11]  T. Cargill,et al.  THE TERM STRUCTURE OF INTEREST RATES: A TEST OF THE EXPECTATIONS HYPOTHESIS , 1975 .

[12]  Robert J. Shiller,et al.  Cointegration and Tests of Present Value Models , 1987, Journal of Political Economy.

[13]  E. Fama,et al.  Forward rates as predictors of future spot rates , 1976 .

[14]  J. Geweke,et al.  Some Joint Tests of the Efficiency of Markets for Forward Foreign Exchange , 1979 .

[15]  Arthur Havenner,et al.  Foreign exchange rates: A multiple currency and maturity analysis , 1988 .

[16]  Frederic S. Mishkin,et al.  An Integrated View of Tests of Rationality, Market Efficiency, and the Short-Run Neutrality of Monetary Policy , 1981 .

[17]  Llad Phillips,et al.  Preferred habitat vs. efficient market: a test of alternative hypotheses , 1976 .

[18]  R. Shiller.  Alternative Tests of Rational Expectations Models: The Case of the Term Structure , 1980 .

[19]  On Forecasting Interest Rates: An Efficient Markets Perspective , 1979 .

[20]  J. Hausman.  Specification tests in econometrics , 1978 .

[21]  J. E. Pesando,et al.  On the Efficiency of the Bond Market: Some Canadian Evidence , 1978, Journal of Political Economy.

[22]  M. A. Grove,et al.  A Model of the Structure of Prices of Marketable U.S. Treasury Securities , 1971 .

[23]  T. Sargent,et al.  Exact linear rational expectations models: specification and estimation , 1981 .

[24]  A. Laffer,et al.  Some evidence on the formation, efficiency and accuracy of anticipations of nominal yields , 1975 .

[25]  R. Shiller.  The Volatility of Long-Term Interest Rates and Expectations Models of the Term Structure , 1979, Journal of Political Economy.

[26]  R. Roll,et al.  The Behavior of Interest Rates: An Application of the Efficient Market Model to U , 1970 .