What is the 'Expectations Theory'
The Expectations Theory – also known as the Unbiased Expectations Theory – 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 bond’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 year’s oneyear bond.
Preferred Habitat Theory
The preferred habitat theory – another termstructure theory – 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.

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