What is the 'Expectations Theory'
The Expectations Theory – also known as the Unbiased Expectations Theory – states that long-term interest rates hold a forecast for short-term interest rates in the future. The theory postulates that an investor earns the same amount of interest by investing in a one-year bond in the present and rolling the investment into a different one-year bond after one year as compared to purchasing a two-year bond in the present.
BREAKING DOWN 'Expectations Theory'
In some instances, the expectations theory is utilized as an explanation for the yield curve. However, the theory has been shown to be inaccurate in execution, because interest rates typically stay flat when the yield curve is normal. Essentially, the expectations theory is known to over-estimate future short-term interest rates.
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