THE PURPOSE OF THIS CHAPTER

In this chapter we define precisely the local expectation hypothesis and excess returns, and we present several convenient expressions for this latter quantity. We do so both for nominal and for real returns.We show how the existence (or otherwise) of systematic excess returns from the strategy of ‘investing long and funding short’ is linked to the validity of the (local) expectation hypothesis.

THE (LOCAL) EXPECTATION HYPOTHESIS

As Sangvinatsos (2008) points out in his helpful review paper, the expectation hypothesis has spawned an immense literature, as the tongue-in-cheek quote by Froot that opens the chapter indicates. This is not surprising, because the expectation hypothesis relates to the evolution of yields, and is of direct relevance for the investment decisions of firms, for monetary policy, for portfolio allocation, and, less directly but not less importantly, for derivatives pricing and hedging. Above all, as Sangvinatsos (2008) says, the expectation hypothesis matters for our economic understanding.

Given its importance, researchers have begun looking into its validity as early as the late 1930s (see, eg, Macaulay (1938), Hicks (1939) and Lutz (1940)). Not surprisingly, the definition of the hypothesis provided in these early days (when Arbitrage Theory and stochastic discount factors were decades in the making) bears little apparent resemblance to the ‘modern’ definition. As Sangvinatsos (2008) says, ‘[t]hese [early versions of the hypothesis] were developed as a need of understanding the returns and yields on long versus short-term bonds, and the time series movements of the term structure. Later, researchers developed theoretical models that give rise to some of the hypothesized equations associated with the expectations hypothesis’.

Despite the apparent differences, the underlying concept (and, more importantly, the underlying economic concern) can be expressed in terms of the Local (or Pure) Expectation Hypothesis, and the Weak Expectation Hypothesis. Confusion is created because some authors speak of the Expectation Hypothesis with any qualification when they refer to the weak version, and other authors when they mean the local variety.