Expectations Theory

Loading the player...

What is the '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.

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 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. Preferred Habitat Theory

    A term structure theory suggesting that different bond investors ...
  2. Biased Expectations Theory

    A theory that the future value of interest rates is equal to ...
  3. Market Segmentation Theory

    A modern theory pertaining to interest rates stipulating that ...
  4. Accelerator Theory

    An economic theory that suggests that as demand or income increases ...
  5. Bond

    A debt investment in which an investor loans money to an entity ...
  6. Bond Yield

    The amount of return an investor will realize on a bond. Several ...
Related Articles
  1. Markets

    Interest Rate Predictions With Expectations Theory

    The expectations theory uses long-term interest rates to predict future short-term interest rates.
  2. Trading

    7 Controversial Investing Theories

    We take a closer look at the theories that attempt to explain and influence the market.
  3. Managing Wealth

    Interest Rates And Your Bond Investments

    By understanding the factors that influence interest rates, you can learn to anticipate their movement and profit from it.
  4. Markets

    Understanding Interest Rates, Inflation And Bonds

    Get to know the relationships that determine a bond's price and its payout.
  5. Managing Wealth

    How To Evaluate Bond Performance

    Learn about how investors should evaluate bond performance. See how the maturity of a bond can impact its exposure to interest rate risk.
  6. Markets

    5 Fixed Income Plays After the Fed Rate Increase

    Learn about various ways that you can adjust a fixed income investment portfolio to mitigate the potential negative effect of rising interest rates.
  7. Markets

    The Effect of Fed Fund Rate Hikes on Your Bond Portfolio

    Learn how an increase in the federal funds rate may impact a bond portfolio. Read about how investors can use the duration of their portfolio to reduce risk.
  8. Personal Finance

    How To Choose The Right Bond For You

    Bond investing is a stable and low-risk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy.
  9. Markets

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  10. Managing Wealth

    5 Basic Things To Know About Bonds

    Learn these basic terms to breakdown this seemingly complex investment area.
RELATED FAQS
  1. What does market segmentation theory assume about interest rates?

    Learn about how the market segmentation theory for different maturities of interest rates seeks to describe the shape of ... Read Answer >>
  2. Do long-term bonds have a greater interest rate risk than short-term bonds?

    The answer to this question lies in the fixed income nature of bonds and debentures, often referred to together simply as ... Read Answer >>
  3. Where did market segmentation theory come from?

    Read about the origin and assumptions of market segmentation theory, a hypothesis about the structure of interest rates and ... Read Answer >>
  4. What's the difference between agency theory and stakeholder theory?

    Learn how agency theory and stakeholder theory are used in business to understand common business communication problems ... Read Answer >>
  5. How does a bull market in stocks affect the bond market?

    Take a deeper look at the relationship between the bond market and equities, and see what might happen to bonds during the ... Read Answer >>
  6. What is affected by the interest rate risk?

    Find out more about interest rate risk, how bond prices are affected by interest rate fluctuations and how interest rate ... Read Answer >>
Hot Definitions
  1. Quantitative Trading

    Trading strategies based on quantitative analysis which rely on mathematical computations and number crunching to identify ...
  2. Bond Ladder

    A portfolio of fixed-income securities in which each security has a significantly different maturity date. The purpose of ...
  3. Duration

    A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. ...
  4. Dove

    An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that ...
  5. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
  6. Front Running

    The unethical practice of a broker trading an equity based on information from the analyst department before his or her clients ...
Trading Center