Expectations Theory
Candlefocus EditorThe theory suggests that a rational investor will not differentiate between investing in two consecutive one-year bond investments and investing in one two-year bond today. This is because, according to the theory, “they will receive the same expected return as if they had invested in the two one-year bonds separately.”
In practice, only longer-term rates tend to be available, making shorter-term rates difficult to observe and predict. Through the Expectations Theory, long-term rates can be used to indicate where rates of short-term bonds will trade in the future. This form of market behavior is known as the Market Expectations Hypothesis.
The theory assumes that investors are rational and will not deviate from the optimal investment decision for their goals and risk tolerance. This means that investors will continually monitor the interest rate environment and adjust their investments accordingly.
Expectations Theory is used to provide an indication of future interest rate changes and helps to inform investment decisions. It is used by investors and analysts to predict how an individual bond’s return might behave over time. By understanding the expectations associated with different interest rates, investors can make informed decisions on whether to hold or buy a bond.