What is the Expectations Theory?
Expectations predict future short-term interest rates based on present long-term interest rates. According to the hypothesis, investing in two successive one-year bonds yields the same interest as investing in a single two-year bond today. Another name for the idea is “unbiased expectations theory.”
Recognizing the Expectations Theory
The expectations theory seeks to assist investors in making choices based on projected interest rate movements in the future. The theory predicts the rate of short-term bonds using long-term rates, usually from government bonds. Theoretically, one may utilize long-term rates to predict future trading prices for short-term bonds.
Estimating Theory of Expectations
Investors may choose between two-year bonds paying 20% interest and one-year bonds paying 18% interest in the current bond market. It is possible to predict the interest rate of a future one-year bond using the expectations theory.
- Adding one to the interest rate of the two-year bond is the first step in the computation. The outcome is 1.2.
- Squaring the result, or (1.2 * 1.2 = 1.44), is the next step.
- To get the result, divide it by the current interest rate for a year and add one (1.44 / 1.18 = 1.22).
- To get the projected interest rate on one-year bonds for the next year, deduct one from the outcome, or (1.22 -1 = 0.22 or 22%).
In this instance, the investor gets a return equal to the bond’s two-year interest rate. For an investment to be profitable, the subsequent year’s bond yield must rise to 22% if the investor decides to purchase a one-year bond at 18%.
By predicting the rate for short-term bonds using long-term rates, usually from government bonds, expectations theory seeks to assist investors in making judgments.
The Expectations Theory’s drawbacks
The expectation theory is only sometimes a trustworthy resource. Therefore, investors need to be aware of this. The expectations theory frequently overestimates future short-term rates, making it easy for investors to mispredict a bond’s yield curve. This is a common issue with the theory.
The fact that various factors affect short- and long-term bond yields is another weakness in the theory. Interest rate changes by the Federal Reserve affect bond yields, particularly those of short-term bonds. Long-term rates, however, are influenced by a wide range of other factors, such as inflation and economic growth expectations so they may be less impacted.
Because of this, the expectations theory ignores the external variables and core macroeconomic principles that influence interest rates and, eventually, bond yields.
Preferred Habitat Theory vs Expectations Theory
The preferred habitat theory expands upon the expectations theory. According to the theory, unless long-term bonds carry a higher risk premium, investors prefer short-term bonds. Put differently, investors seek a higher yield to offset the risk of holding onto a long-term bond until it matures if they plan to hold onto it.
The preferred habitat hypothesis may help to explain why longer-term bonds typically yield a higher interest rate than two shorter-term bonds with the same maturity when joined together.
The preferred habitat theory differs from the expectations theory, assuming investors care about age and yield. On the other hand, the expectations theory assumes that investors are only focused on yield.
Conclusion
- Based on current long-term interest rates, expectations theory forecasts short-term interest rates for the future.
- According to the hypothesis, investing in two successive one-year bonds yields interest at the same rate as investing in a single two-year bond today.
- Theoretically, one may utilize long-term rates to predict future trading prices for short-term bonds.
