What is the 'Expectations Theory'
The Expectations Theory â€“ also known as the Unbiased Expectations Theory â€“ states that longterm interest rates hold a forecast for shortterm interest rates in the future. The theory postulates that an investor earns the same amount of interest by investing in a oneyear bond in the present and rolling the investment into a different oneyear bond after one year as compared to purchasing a twoyear bond in the present.
BREAKING DOWN 'Expectations Theory'
In some instances, the expectations theory is utilized as an explanation for the yield curve. However, the theory has been shown to be inaccurate in execution, because interest rates typically stay flat when the yield curve is normal. Essentially, the expectations theory is known to overestimate future shortterm interest rates.Example
Consider that the present bond market provides investors with a twoyear bond that has an interest rate of 20% and a oneyear bond with an interest rate of 18%. The expectations theory can be utilized to forecast the interest rate for the oneyear bond in one year. The first step of the calculation is to add one to the twoyear bondâ€™s interest rate. In this example, the result is 1.2, or 120%.
The next step is to square the result; 1.2 squared results in 1.44. This number is then divided by the current oneyear interest rate plus one. This means that 1.44 is divided by 1.18 to equal 1.22. Subtracting one from that sum is the final step and results in a predicted oneyear bond interest rate of 22% for the following year.
In this example, the investor, theoretically, is earning an equivalent return to the present interest rate of a twoyear bond. If the investor chooses to invest in a oneyear bond at 18%, he has to hope for the bond yield to increase to 22% for the following yearâ€™s oneyear bond.
Preferred Habitat Theory
The preferred habitat theory â€“ another termstructure theory â€“ is an expansion of the expectations theory and is used to explain why longerterm bonds typically pay out higher interest than two shorterterm bonds that, added together, result in the same maturity. The theory states that investors have a preference for shortterm bonds over longterm bonds, unless that latter pays a risk premium. When comparing the preferred habitat theory to the expectations theory, the difference is that the former assumes investors are concerned with maturity as well as yield, while the expectations theory assumes that investors are only concerned with yield.

Preferred Habitat Theory
A term structure theory suggesting that different bond investors ... 
Biased Expectations Theory
A theory that the future value of interest rates is equal to ... 
Market Segmentation Theory
A modern theory pertaining to interest rates stipulating that ... 
Bond Yield
The amount of return an investor will realize on a bond. Several ... 
Bond
A debt investment in which an investor loans money to an entity ... 
Deferred Interest Bond
A debt instrument that pays interest only upon maturity. Unlike ...

Investing
Interest Rate Predictions With Expectations Theory
The expectations theory uses longterm interest rates to predict future shortterm interest rates. 
Investing
Understanding Interest Rates, Inflation And Bonds
Get to know the relationships that determine a bond's price and its payout. 
Investing
7 Controversial Investing Theories
We take a closer look at the theories that attempt to explain and influence the market. 
Investing
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. 
Investing
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. 
Investing
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. 
Investing
How To Choose The Right Bond For You
Bond investing is a stable and lowrisk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy. 
Investing
Corporate Bond Basics: Learn to Invest
Understand the basics of corporate bonds to increase your chances of positive returns. 
Investing
Six Biggest Bond Risks
Don't assume that you can't lose money in this market  you can. Find out how. 
Financial Advisor
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.

Do longterm bonds have a greater interest rate risk than shortterm bonds?
The answer to this question lies in the fixed income nature of bonds and debentures, often referred to together simply as ... Read Answer >> 
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 >> 
What causes a bond's price to rise?
Learn about factors that influence the price of a bond, such as interest rate changes, credit rating, yield and overall market ... Read Answer >> 
What determines the price of a bond in the open market?
Learn more about some of the factors that influence the valuation of bonds on the open market, and why bond prices and yields ... Read Answer >> 
What types of investors are susceptible to interest rate risk?
Learn how bondholders are more susceptible to interest rate risk than equity investors because of the direct correlation ... Read Answer >>