Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Expectations Theory

What it is:

Expectations theory suggests that the forward rates in current long-term bonds are closely related to the bond market's expectation about future short-term interest rates. 

How it works (Example):

Expectations theory attempts to explain the term structure of interest rates. There are three main types of expectations theories: pure expectations theory, liquidity preference theory and preferred habitat theory.

Expectations theories are predicated upon the idea that investors believe forward rates, as reflected (and some would say predicted) by future contracts are indicative of future short-term interest rates. 

For example, if 3 months from today you want to buy a 6-month T-bill, you would look at the forward rate on the 6-month T-bill to see what its expected yield is projected to be in 3 months. Let's assume the forward rate is 1% for that specific T-bill. In this case, expectations theory would suggest that the 6-month interest rate 3 months from today will be 1%.

Why it Matters:

Investors make decisions partially based upon where they foresee the future level of interest rates. Expectations theory implies that long-term investors will choose to purchase or not to purchase debt instruments based on whether forward interest rates are more or less favorable than current short-term interest rates.

Related Terms View All
  • Vest Fleece
    For example, let's assume that John Doe receives options to buy 2,000 shares of Company...
  • National Association of Insurance and Financial Advisors (NAIFA)
    Founded in 1890, the organization originally was called The National Association of Life...
  • Old Lady
    The Bank of England is the United Kingdom's central bank, meaning that it is a bank for...
  • Nakahara Prize
    The board of directors of the Japanese Economic Association determines who wins the...
  • Vernon L. Smith
    Born in 1927 in Wichita, Kansas, Vernon L. Smith earned an engineering degree from Cal...