What is expectations hypothesis?
This is a formula used to predict interest rates. It's based on the idea that long-term interest rates can help forecast short-term interest rates in the future.
Where have you heard about expectations hypothesis?
It's sometimes used as an explanation for the yield curve, a line plotting interest rates of bonds with different maturity dates, but the same credit quality. However, this has been found to be inaccurate.
What you need to know about expectations hypothesis.
The basic idea behind the theory is that the expected value of investing in a sequence of short-term bonds will be the same as investing in long-term bonds. So, if an investor invests in a one-year bond and rolls it into another one-year bond after a year, they will earn the same interest as they would purchasing a two-year bond initially. However, the theory has been shown to over-estimate future interest rates. It also does not take into account the inherent risk of investing in bonds.
Find out more about expectations hypothesis.
See our guide to the preferred habitat theory to find out more about how interest rates can be explained.