THE TERM STRUCTURE OF INTEREST RATES, PORTFOLIO THEORY, AND THE ROLE OF LENGTH TO MATURITY IN SELECTING UNITED STATES GOVERNMENT SECURITIES

THE ROLE ASCRIBED to maturity vis a vis anticipated interest rates is a basic issue in term-structure theory. David Meiselman's model-the expectations hypothesis and his forecasting framework which uses an error-learning model-assumes that portfolios are chosen according to expected interest rates. The expectations hypothesis holds that in equilibrium one plus any n-period yield equals the geometric mean of one plus each of the n single-period yields expected over the same time span. Alternatively, it is argued that the rate structure reflects supply and demand conditions in separate markets for securities of different maturity. This follows from assuming that investors select portfolios on the basis of maturity. In response, this dissertation comprises three related studies: (1) an historical and critical review of the expectations hypothesis; (2) an attempt to show that maturity diversification follows from the uncertainty of future interest rates; (3) use of daa from the U.S. Treasury Survey of Ownership to examine the maturity distribution of institutional portfolios. Historically, the expectations hypothesis is associated with Irving Fisher, John R. Hicks, Frederick R. Macaulay, and John Burr Williams. Common to their research is the definition of an average rate or return over n periods in terms of n certain one-period interest rates. Although this tautology can be derived from the presentvalue formula, Fisher and Hicks discuss it with reference to an economic analogue, viz., if future one-period interest rates are certain, then a package of n successive single-period loans is identical to one loan extending over the same n periods. The initial link between the tautology and market phenomena appears in Macaulay and Fisher. Both imply that the observed behavior of long-term relative to short-term interest rates is similar to the statistical relationship between a mean and its individual components: The variance of long-term rates is less than the variance of short-term rates just as the variance of means (the sampling distribution) is less than that of the parent population. However, this analogy does not provide a basis for Williams' assertion that long-term rates are an average of short-term rates. Friedrich A. Lutz and David Meiselman argue from postulated investor behavior that the tautology can be viewed as a condition for market equilibrium vis d vis its use in the purely descriptive analogy presented above. However, employing assumptions to convert a tautology into an equilibrium condition is questionable. If oneperiod rates are certain for n periods hence, all transactors know what these rates are, and if roll-over costs are zero, then the n-period interest rate can be calculated from the tautology. That is all. Concepts such as "market" and "equilibrium" are not applicable. Indeed, these notions form no part of the derivations presented by Fisher and Hicks. The expectations hypothesis and the error-learning model apparently apply when future one-period rates are uncertain. However, the shift from certainty to uncertainty is effected only by substituting "expected" for "certain" in the tautology.