What explains deviations in the unbiased expectations hypothesis? Market irrationality vs. the peso problem

• We provide a simple method to decompose the expectation error.
• We find that investor sentiment and the peso problem play a significant role in explaining expectation errors.
• Irrationality contributes more to the expectation error during crises.

Evidence from this study suggests that investor sentiment and the peso problem play a significant role in explaining expectation errors, rejecting the unbiased expectation hypothesis (UEH). The deviation of the UEH for long-term rates is mainly attributable to expectation errors, whereas the deviation of short-term rates is tied to the term premium. We decompose expectation errors and find that irrationality is more apparent in crisis periods, and the rational component becomes an influential factor in tranquil periods.