Testing the Expectations Hypothesis of the Term Structure of Interest Rates in the Presence of a Potential Regime Shift.

The expectations hypothesis of the term structure of interest rates is tested using monthly Eurodollar deposit rates for maturities 1, 3 and 6 months covering the period 1983:1 -1996:6.Whereas classical regression-based tests indicate rejection, tests based on a new model allowing for potential -but unrealized- regime shifts provide support for the expectations hypothesis. The peso problem is modelled by means of a threshold autoregression. The estimation results suggest that potential regime shift had an effect on expectations concerning the longer-term interest rate only for a short while in the early phase of the sample period, when interest rates were at their highest.