Are German money market rates well behaved?

We test the expectations hypothesis (EH) of the term structure of interest rates for the German money market at the short end of the maturity spectrum using a variety of metrics, and on balance we argue that the results tend to broadly support the hypothesis. We utilise monthly data on pure discount bonds with a maturity from 1 to 12 months over the period of 1976 to 1993. The VAR methodology is used to forecast future interest rates which, under the EH, results in a set of cross-equation restrictions as well as tests based on the correspondence between the best forecast (referred to as the 'theoretical spread') and the actual spread. The VAR methodology allows explicit consideration of potential non-stationarity in the data as do our tests based on the cointegration literature. We also perform more conventional tests, based on applying the rational expectations (RE) hypothesis in a single equation framework. Our relatively favourable results for the EH are in sharp contrast to those found in studies using US data and this we attribute in part to the policy of sustained credible monetary targeting by the Bundesbank. (C) 2000 Elsevier Science B.V. All rights reserved.