What is the 'Expectations Theory'
The hypothesis that longterm interest rates contain a prediction of future shortterm interest rates. Expectations theory postulates that you would earn the same amount of interest by investing in a oneyear bond today and rolling that investment into a new oneyear bond a year later compared to buying a twoyear bond today.
BREAKING DOWN '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 shortterm interest rates.
Another termstructure theory, preferred habitat theory, expands on expectations theory to explain why longerterm bonds tend to pay more interest than two shorterterm bonds that add up to the same maturity. It says that investors prefer shortterm bonds and are only interested in longerterm 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.

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