Expectations Theory

AAA

DEFINITION of 'Expectations Theory'

The hypothesis that long-term interest rates contain a prediction of future short-term interest rates. Expectations theory postulates that you would earn the same amount of interest by investing in a one-year bond today and rolling that investment into a new one-year bond a year later compared to buying a two-year bond today.

INVESTOPEDIA EXPLAINS 'Expectations Theory'

This theory is sometimes used to explain the yield curve but has proven inaccurate in practice as interest rates tend to remain flat when the yield curve is normal. In other words, expectations theory often overstates future short-term interest rates.

Another term-structure theory, preferred habitat theory, expands on expectations theory to explain why longer-term bonds tend to pay more interest than two shorter-term bonds that add up to the same maturity. It says that investors prefer short-term bonds and are only interested in longer-term bonds if they pay a risk premium. While expectations theory assumes that investors only care about yield, preferred habitat theory assumes they care about maturity as well as yield.

RELATED TERMS
  1. Fiscal Policy

    Government spending policies that influence macroeconomic conditions. ...
  2. Federal Funds Rate

    The interest rate at which a depository institution lends funds ...
  3. Fed Model

    A model thought to be used by the Federal Reserve that hypothesizes ...
  4. Debenture

    A type of debt instrument that is not secured by physical assets ...
  5. Interest Rate

    The amount charged, expressed as a percentage of principal, by ...
  6. Bond

    A debt investment in which an investor loans money to an entity ...
Related Articles
  1. Earnings: Quality Means Everything
    Investing

    Earnings: Quality Means Everything

  2. Forces Behind Interest Rates
    Economics

    Forces Behind Interest Rates

  3. Explaining The World Through Macroeconomic ...
    Options & Futures

    Explaining The World Through Macroeconomic ...

  4. Dividends, Interest Rates And Their ...
    Options & Futures

    Dividends, Interest Rates And Their ...

comments powered by Disqus
Hot Definitions
  1. Ghosting

    An illegal practice whereby two or more market makers collectively attempt to influence and change the price of a stock. ...
  2. Elasticity

    A measure of a variable's sensitivity to a change in another variable. In economics, elasticity refers the degree to which ...
  3. Tangible Common Equity - TCE

    A measure of a company's capital, which is used to evaluate a financial institution's ability to deal with potential losses. ...
  4. Yield To Maturity (YTM)

    The rate of return anticipated on a bond if held until the maturity date. YTM is considered a long-term bond yield expressed ...
  5. Net Present Value Of Growth Opportunities - NPVGO

    A calculation of the net present value of all future cash flows involved with an additional acquisition, or potential acquisition. ...
  6. Gresham's Law

    A monetary principle stating that "bad money drives out good." In currency valuation, Gresham's Law states that if a new ...
Trading Center