ORIGINAL RESEARCH Surprises, sentiments, and the expectations hypothesis of the term structure of interest rates Cathy Yi-Hsuan Chen 1,2 • Thomas C. Chiang 3 Ó Springer Science+Business Media New York 2016 Abstract This study shows that time-varying coefficients in the term structure of interest rates equation are correlated with the time-varying term premiums (TVTP) and expectation error (EE). Consistent with Froot (J Finance 44:283–305, 1989), TVTP and EE are the main factors that cause variations in the expectations hypothesis. Once the TVTP and the EE are appropriately incorporated into the model, the GARCH-M evidence fades away. This study documents that investors’ sentiment and macroeconomic surprises are the main driving forces behind the TVTP and EE. Evidence of significant sentiment and its interacting with macroeconomic surprises shed some light on the bias due to behavioral variations. Keywords Expectations hypothesis  Time-varying coefficient model  Sentiment  Expectation error  Term premium JEL Classification E43  G12  G14 1 Introduction The expectations hypothesis of the term structure of interest rates has been extensively tested in the literature. Earlier studies by Fama (1984) and Mishkin (1988) favorably support the notion of forward market efficiency that the forward spot rate spread has & Cathy Yi-Hsuan Chen chencath@hu-berlin.de Thomas C. Chiang chiangtc@drexel.edu 1 Ladislaus von Bortkiewicz Chair of Statistics, C.A.S.E. - Center for Applied Statistics and Economics, Humboldt-Universita ¨t zu Berlin, Unter den Linden 6, 10099 Berlin, Germany 2 Department of Finance, Chung Hua University, 707, Sec. 2, WuFu Rd., Hsinchu 300, Taiwan, ROC 3 LeBow College of Business, Drexel University, Gerri LeBow Hall, 3220 Market Street, Philadelphia, PA 19104, USA 123 Rev Quant Finan Acc DOI 10.1007/s11156-016-0584-y