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 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."

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.

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.

Disadvantages 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.

Another limitation of the theory is that many factors impact short-term and long-term bond yields. The Federal Reserve adjusts interest rates up or down, which impacts bond yields, including short-term bonds. However, long-term yields might be less affected because many other factors impact long-term yields, including inflation and economic growth expectations. As a result, the expectations theory does not consider the outside forces and fundamental macroeconomic factors that drive interest rates and, ultimately, bond yields.

Expectations Theory Versus Preferred Habitat Theory

The preferred habitat theory takes the expectations theory one step further. The theory states that investors have a preference for short-term bonds over long-term bonds unless the latter pay a risk premium. In other words, if investors are going to hold onto a long-term bond, they want to be compensated with a higher yield to justify the risk of holding the investment until maturity.

The preferred habitat theory can help explain, in part, why longer-term bonds typically pay out a higher interest rate than two shorter-term bonds that, when added together, result in the same maturity.

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. In contrast, the expectations theory assumes that investors are only concerned with yield.