DEFINITION of Biased Expectations Theory

The biased expectations theory is a theory that the future value of interest rates is equal to the summation of market expectations. In the context of foreign exchange, it is the theory that forward exchange rates for delivery at some future date will be equal to the spot rate for that day as long as there is no risk premium.

BREAKING DOWN Biased Expectations Theory

Proponents of the biased expectations theory argue that the shape of the yield curve is created by ignoring systematic factors and that the term structure of interest rates is solely derived by the market's current expectations. In other words, the yield curve is shaped from market expectations about future rates and from the higher premium required of investors looking to invest in bonds with longer maturities.

Two common biased expectation theories are the liquidity preference theory and the preferred habitat theory. The liquidity theory suggests that long-term bonds contain a risk premium and the preferred habitat theory suggests that the supply and demand for different maturity securities are not uniform and therefore there is a difference in risk premium for each security.

Liquidity Preference Theory

In simple term, the liquidity theory implies that investors prefer and will pay a premium for liquid assets. The liquidity theory of the term structure of interest rates follows that the forward rate reflects the higher rate demanded of investors for longer-term bonds. The higher rate required is a risk or liquidity premium that is determined by the difference between the rate on longer maturity terms and the average of expected future rates. Forward rates, then, reflect both interest rate expectations and a risk premium which should increase with the term of the bond. This explains why the normal yield curve slopes upward, even if future interest rates are expected to remain flat or even decline a little. Because they carry a risk premium, forward rates will not be an unbiased estimate of the market expectations of future interest rates.

According to this theory, investors have a preference for short investment horizons and would rather not hold long term securities which would expose them to a higher degree of interest rate risk. To convince investors to purchase the long-term securities, issuers must offer a premium to compensate for the increased risk. The liquidity theory can be seen in the normal yields of bonds in which longer term bonds, which typically have lesser liquidity and carry a higher interest rate risk than shorter term bonds, have a higher yield to incentivize investors to purchase the bond.

Preferred Habitat Theory

Like the liquidity preference theory, the preferred habitat theory asserts that the yield curve reflects the expectation of future interest rate movements and a risk premium. However, the theory rejects the position that risk premium should be increased with maturity.

The preferred habitat theory postulates that interest rates on short-term bonds and on long-term bonds are not perfect substitutes, and investors have a preference for bonds of one maturity over another. In other words, bond investors prefer a certain segment of the market based on term structure or the yield curve and will not opt for a long term debt instrument over a short term bond with the same interest rate. Investors will be willing to purchase a bond of a different maturity only if they earn a higher yield for investing outside their preferred habitat, that is, preferred maturity space. For instance, bondholders who prefer to hold short-term securities due to the interest rate risk and inflation impact on longer term bonds will purchase long-term bonds if the yield advantage on the investment is significant.