## What Is Expectations Theory

Expectations theory attempts to predict what short-term interest rates will be in the future based on current long-term interest rates. The theory suggests that an investor earns the same amount of interest by investing in two consecutive one-year bond investments versus investing in one two-year bond today. The theory is also known as the "unbiased expectations theory."

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## Understanding Expectations Theory

The expectations theory aims to help investors make decisions based upon a forecast of future interest rates. The theory uses long-term rates, typically from government bonds, to forecast the rate for short-term bonds. In theory, long-term rates can be used to indicate where rates of short-term bonds will trade in the future.

## Example of Calculating Expectations Theory

Let's say that the present bond market provides investors with a two-year bond that pays an interest rate of 20% while a one-year bond pays an interest rate of 18%. The expectations theory can be used to forecast the interest rate of a future one-year bond.

• The first step of the calculation is to add one to the two-year bond’s interest rate. The result is 1.2.
• The next step is to square the result or (1.2 * 1.2 = 1.44).
• Divide the result by the current one-year interest rate and add one or ((1.44 / 1.18) +1 = 1.22).
• To calculate the forecast one-year bond interest rate for the following year, subtract one from the result or (1.22 -1 = 0.22 or 22%).

In this example, the investor is earning an equivalent return to the present interest rate of a two-year bond. If the investor chooses to invest in a one-year bond at 18% the bond yield for the following year’s bond would need to increase to 22% for this investment to be advantageous.

• Expectations theory attempts to predict what short-term interest rates will be in the future based on current long-term interest rates
• The theory suggests that an investor earns the same amount of interest by investing in two consecutive one-year bond investments versus investing in one two-year bond today
• ﻿In theory, long-term rates can be used to indicate where rates of short-term bonds will trade in the future

Expectations theory aims to help investors make decisions by using long-term rates, typically from government bonds, to forecast the rate for short-term bonds.