PARAMETER UNCERTAINTY AND THE RATIONAL-EXPECTATIONS MODEL OF THE TERM STRUCTURE

Numerous previous studies have observed that excess holding period returns on long-term securities are correlated with yield spreads observable at the beginning of the period in apparent violation of the joint hypothesis consisting of the expectations model of the term structure and the rational expectations-efficient markets hypothesis. We show that the existing evidence is only inconsistent with the joint hypothesis if 'rational expectations' means that expectations are Muth rational, i.e., that market participants know the exact true parameters of the process linking current information to future interest rates. If they do not know but must estimate these parameters, then the usual results will be observed even if the joint hypothesis holds.