Expectations Theory

A theory proposing that long-term interest rates can act as a predictor of future short-term interest rates.

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Empirical evidence suggests this hypothesis often overstates future short-term interest rates. This over-estimation may be due to the higher risk premium associated with holding a long-term debt security whose yield is more uncertain due to potential changes in interest rates.

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Understand the various factors that influence them so you can learn to anticipate their movements for profit. Trying To Predict Interest Rates

Interest rate theory that says the anticipated Yield on successive maturities of the same security is determined by investor expectations of future interest rates. An investor is said to be motivated by rational expectations when an investment decision is based on all available information. The expectations theory tries to explain the term structure of interest rates by saying that any combination of maturities produces roughly the same average yield. Investors willing to accept 6% on one-year certificates of deposit, anticipating next year's one-year rate will be 8%, expect the current rate on two-year CDs will be 7%, the average of the two rates (6% + 8% / 2 = 7%). Investors anticipating rising short-term interest rates will buy more of short maturity securities, which influences the slope of the Yield Curve. Contrast with the Market Segmentation Theory. See also Inverted Yield Curve; Liquidity Preference Theory.