The Term Structure of Interest Rates in a Partially Observable Economy



    Search for more papers by this author
    • Department of Finance, University of Illinois at Chicago. This work was supported by the Dean's Fund, Owen Graduate School of Management, Vanderbilt Unioversity; Summer Grant, Graduate School of Industrial Administration, Carnegie Mellon University; and the Center for Research in Security Prices, Graduate School of Business, University of Chicago. I thank Avraham Beja, George Constantinides, Uri Dothan, Philip Dybvig, Zvi Eckstein, Shmuel Kandel, Dan Peled, and Linda Hutz Pesante for helpful discussions.


This paper investigates the term structure of interest rates in a multiperiod production and exchange economy with incomplete information. Unable to observe their stochastic investment opportunities, investors engage in dynamic Bayesian inference. This results in the endogenous identification of a more complex production function which generates a richer term structure, resembling the one that actual market prices imply. In addition, this paper introduces a characteristic function of the term structure and demonstrates that, in contrast with a fully observable economy, the widely investigated expectations hypothesis holds true only if interest rates are nonstochastic.