Expectations Theory

What is the Expectations Theory?

Expectations theory attempts to forecast short term interest rates based on the current long-term rates by assuming no arbitrage opportunity and therefore implying that two investment strategies spread in a similar time horizon should yield an equal amount of returns. For example, Investment in bonds for two consecutive one-year bonds yields the same interest as investing in a two-year bond today.

Explanation

  • It assists the investors to foresee the future interest rates and also assist in the investment decision making; depending on the outcome from the expectations theory, the investors will figure out if the future rates are favorable or not for investment.
  • Long-term rates used in theory are typically government bond rates, which helps the analyzers to predict the short-term rates and also to forecast where these short-term rates will trade in the future.
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Types of Expectations Theory

Types of Expectations Theory

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#1 – Pure Expectations Theory

The assumption of this theory is that forward ratesForward RatesThe forward rate formula deciphers the yield curve, a graphical representation of yields on different bonds with different maturity periods. Forward rate = [(1 + S1)n1 / (1 + S2)n2]1/(n1-n2) – 1read more represent the upcoming future rates. In a way, the term structure represents the market expectation on short-term interest rates.

#2 – Liquidity Preference Theory

In this theory, liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses.read more is given preference, and investors demand a premium or higher interest rate on the securities with long maturity since more time means more risk associated with the investment.

#3 – Preferred Habitat Theory

Different bond investors prefer one maturity length over others and also that they are willing to buy these bonds if enough calculate risk premiumCalculate Risk PremiumRisk Premium, also known as Default Risk Premium, is the expected rate of return that the investors receive for their high-risk investment. You can calculate it by deducting the Risk-Free Investment Return from the Actual Investment Return. read more is yielded on such bonds. In this theory, everything else equal, the basic assumption is that investor preferred bonds are short term bonds over long term bonds, indicating that long term bonds yield more than short term bonds.

Examples

  • An investor is looking at the current bond market and is confused about his investment options, where he has the below information available:
    • The one-year interest rate for a bond maturing in one year = 3.5%
    • A bond maturing in 2 years having an interest rate of 4%
    • The rate for one-year maturity bond one year from now will be assumed as F1
  • So, there are two choices in front of the investor either he chooses to invest in a 2-year bond or invest in consecutive one-year bonds, but which investment will yield him good returns.
  • Let us calculate using the expectations theory assumption: (1+0.035)*(1+F1) = (1+0.04) ^2
  • Now we calculate for F1 = 4.5%, so in both the scenarios, investors will earn an average of 4% annually.

Difference Between Expectations Theory and Preferred Habitat Theory

  • In the preferred habitat theory, the investor prefers short term duration bonds as compared to long term duration bonds, in only the case where long-term bonds pay a risk premium, an investor will be willing to invest in the same.
  • As opposed to expectation theory, where it assumes that short term bonds and long term bonds yield the same returns, preferred habitat theory explains that why single long term bonds pay a higher interest rate as compared to the interest rates of two short term bonds added together with the same maturity.
  • The major difference between the two would be wherein preferred habitat theory, and an investor is concerned with the duration and yield while the expectations theory only gives preference to yield.

Advantages

Disadvantages

Conclusion

This is a tool used by investors to analyze short-term and long-term investment options. The theory is purely based on assumption and formula. However, the investment decision should not have only relied upon this theory. People should just use it as a tool to analyze the health of the market and combine the analysis with other strategies to get reliable investment choice.

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