Discover the Secrets of Expectations Theory: Predicting Future Interest Rates
Expectations Theory predicts future short-term interest rates based on current long-term interest rates. The theory suggests that investing in two consecutive one-year bonds yields the same return as investing in one two-year bond today. This theory is also referred to as the ‘unbiased expectations theory.’
- Expectations Theory predicts future short-term interest rates based on current long-term interest rates.
- It suggests that an investor earns the same amount of interest by investing in two consecutive one-year bond investments versus investing in one two-year bond today.
- Long-term rates can theoretically indicate where rates of short-term bonds will trade in the future.
Mastering Expectations Theory
Expectations Theory helps investors make decisions based on a forecast of future interest rates. The theory uses long-term rates, typically from government bonds, to forecast the rate for short-term bonds.
Calculating Expectations Theory
Suppose the current bond market offers a two-year bond with an interest rate of 20%, while a one-year bond provides an interest rate of 18%. Expectations Theory can forecast the interest rate of a future one-year bond.
- Add one to the two-year bond’s interest rate (1.20)
- Square the result (1.20 * 1.20 = 1.44)
- Divide by the current one-year interest rate and add one ((1.44/1.18) + 1 = 1.22)
- Subtract one to determine the forecasted one-year bond interest rate for the following year (1.22 - 1 = 0.22 or 22%)
Note: In this scenario, the investor achieves an equivalent return to the present rate of a two-year bond. If the investor opts for a one-year bond at 18%, the yield for the subsequent year’s bond must rise to 22% to make this choice beneficial.
Addressing the Drawbacks of Expectations Theory
While useful, Expectations Theory is not always dependable. It can overestimate future short-term rates, leading to inaccurate predictions of a bond’s yield curve. Additionally, the theory overlooks many influences on bond yields such as Federal Reserve interest rate adjustments, inflation, and economic growth expectations. Consequently, it often fails to account for macroeconomic factors impacting interest rates and bond yields.
Exploring Expectations Theory Vs. Preferred Habitat Theory
Preferred Habitat Theory extends Expectations Theory by suggesting that investors prefer short-term bonds over long-term ones unless compensated with a risk premium. Simply put, if investors hold long-term bonds, they expect higher yields to offset the risk of holding the investment until maturity.
Preferred Habitat Theory helps explain why long-term bonds usually offer higher payouts than a combination of short-term bonds totaling the same maturity. Unlike Expectations Theory, which assumes investors only seek yield, Preferred Habitat Theory considers both maturity and yield in investors’ preferences.
Related Terms: interest rates, bond market, yield curve, risk premium, maturity.
