Loading the player...

What is the 'Expectations Theory'

The 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 a one-year bond now and then another one-year bond after the first bond matures, as compared to purchasing a two-year bond in the present. This theory is also known as the Unbiased Expectations Theory.

Breaking Down 'Expectations Theory'

The expectations theory aims to help investors make decisions based upon a forecast of future interest rates. There are three primary theories associated with the expectations theory, which are preferred habitat theory, pure expectations theory and liquidity preference theory. Each one of these is considered a type of expectations theory.

Investors should be aware that the expectations theory is not always a reliable tool. A common problem with using the expectations theory is that it sometimes overestimates future short-term rates, making it easy for investors to end up with an inaccurate prediction of a bond’s yield curve.

Consider that the present bond market provides investors with a two-year bond that has an interest rate of 20 percent and a one-year bond with an interest rate of 18 percent. 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, or 120 percent.

The next step is to square the result, and then divide the result by the current one-year interest rate plus one. To get a predicted one-year bond interest rate for the following year, subtract one from that sum.

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 percent, the bond yield for the following year’s bond would need to increase to 22 percent for this investment to be advantageous.

Expectations Theory vs. Preferred Habitat Theory

The preferred habitat theory expands upon the expectations theory. People sometimes use this theory to explain why longer-term bonds typically pay out higher interest than two shorter-term bonds that, when added together, result in the same maturity.

The theory states that investors have a preference for short-term bonds over long-term bonds, unless the latter pay 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.

  1. Mechanism Design Theory

    Mechanism design theory is an economic theory that seeks to study ...
  2. Liquidity Preference Theory

    Liquidity preference theory deals with how people value cash ...
  3. New Growth Theory

    New growth theory is a concept that presumes the desire and wants ...
  4. Rational Expectations Theory

    The rational expectations theory posits that individuals make ...
  5. Prospect Theory

    Prospect theory argues that if given the option, people prefer ...
  6. Import Substitution Industrialization ...

    Import substitution industrialization is an economic theory of ...
Related Articles
  1. Investing

    Modern Portfolio Theory Vs. Behavioral Finance

    Or: How financial markets would work in an ideal world vs. how they work in the real world.
  2. 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.
  3. Investing

    How Rising Interest Rates Impact Bond Portfolios

    A look at the impact that changing interest rates - rising or falling - have on bonds and what investors need to consider.
  4. Investing

    Investing in Bonds: 5 Mistakes to Avoid in Today's Market

    Investors need to understand the five mistakes involving interest rate risk, credit risk, complex bonds, markups and inflation to avoid in the bond market.
  5. Investing

    Explaining the Liquidity Preference Theory

    According to the liquidity preference theory, investors demand interest in return for sacrificing their liquidity.
  6. Investing

    Key Strategies To Avoid Negative Bond Returns

    It is difficult to make money in bonds in a rising rate environment, but there are ways to avoid losses.
  7. Investing

    Corporate Bonds for Retirement Accounts

    Corporate bonds are usually the preferred choice in retirement accounts. Here are some of the benefits of corporate bonds, and strategies for a portfolio.
  8. Investing

    The Best Bet for Retirement Income: Bonds or Bond Funds?

    Retirees seeking income from their investments typically look into bonds. Here's a look at the types of bonds, bond funds and their pros and cons.
  9. Investing

    How Rising Interest Rates and Inflation Affect Bonds

    Understand bonds better with these four basic factors.
  1. What's the difference between agency theory and stakeholder theory?

    Agency theory and stakeholder theory are both used to understand and explain various types of relationships and challenges ... Read Answer >>
Trading Center