Question

Explain Interest Rate Expectations theory and provide an example?

Answer 1

Expectations theory explains the current forward interest rates of the current long-term bonds are related to the market expectation of the bond’s future short-term interest rates. The theory considered here three theories: pure expectations theory, preferred habitat theory and liquidity preference theory. The investors as per habit predicts the yield rate by expecting the future short-term interest on the bond. The average of the long term interest rates will provide expected future short term interest rates.

Like, if you need to invest in bonds after 6 months for a period of 6 months. We look for the forward rate on 1 year bond, so that we would able to predict the expected future yield of investment 6 months

Moreover, the expectations theory also explains that long-term interest rates of bonds can be used to predict future short-term interest rates for different investments in bonds.

Like, if you go for 1 year bond investment say on 5%, then the yield on the two 6-months investments of 3% and 7% on consecutive investment would be equal on an average basis.