Where (and by How Much) Does a Theory Break Down? With an Application to the Expectation Hypothesis

Abstract

The authors provide new evidence in favor of the expectation hypothesis (EH) as a long-run theory of the term structure of interest rates. Using nonparametric techniques first, the authors show that the results of conventional tests that reject EH are strongly affected by the presence of extreme observations – only a handful in the case of longer maturities. The authors then provide a new general methodology that determines the number of outliers causing any theory to fail, and their approach quantifies the extent of this failure.

Citation

Abadir, K.M. and Atanasova, C. (2022), "Where (and by How Much) Does a Theory Break Down? With an Application to the Expectation Hypothesis", Chudik, A., Hsiao, C. and Timmermann, A. (Ed.) Essays in Honor of M. Hashem Pesaran: Panel Modeling, Micro Applications, and Econometric Methodology (Advances in Econometrics, Vol. 43B), Emerald Publishing Limited, Leeds, pp. 255-267. https://doi.org/10.1108/S0731-90532021000043B011