What is Expectations Theory?
Expectations theory suggests that the forward rates in current long-term bonds are closely related to the bond market's expectation about future short-term interest rates.
How Does Expectations Theory Work?
Expectations theory attempts to explain the term structure of interest rates. There are three main types of expectations theories: pure expectations theory, liquidity preference theory and preferred habitat theory.
Expectations theories are predicated upon the idea that investors believe forward rates, as reflected (and some would say predicted) by future contracts are indicative of future short-term interest rates.
For example, if 3 months from today you want to buy a 6-month T-bill, you would look at the forward rate on the 6-month T-bill to see what its expected yield is projected to be in 3 months. Let's assume the forward rate is 1% for that specific T-bill. In this case, expectations theory would suggest that the 6-month interest rate 3 months from today will be 1%.
Why Does Expectations Theory Matter?
Investors make decisions partially based upon where they foresee the future level of interest rates. Expectations theory implies that long-term investors will choose to purchase or not to purchase debt instruments based on whether forward interest rates are more or less favorable than current short-term interest rates.