Abstract
Numerous studies have found that ex-post excess holding periodreturns on long-term securities are positively correlated with current long-short yield spreads. These findings are inconsistent withthe expectations hypothesis of the term structure and are explainedby many as reflecting the under-reactions of long-term interestrates to changes in short-term interest rates. In this paper, we demonstrate that the existence of transaction costs cound be a theoretical reason for such under-reactions. By employing data on U.S. sixmonth and three-month Treasury bill rates, we found that providedU.S. bill markets are dominated by risk neutral arbitragers, transaction costs with a magnitude roughly equal to average threemonth (or six-month) bill bid ask yield spreads could easily accountfor the positive correlation between ex-post excess holding periodreturns on six-month bills and six-month three-month bill yieldspreads documented in the literature.