Expectations Theory

Expectations theory is significant as it explains global economic and investment analytics and predicts the future.

The expectation is of participants in the global financial markets, and it is considered important by the central banks to forecast and decision making.

It suggests the observed term structure can be used to infer market participants’ visions about future rates and how the events can influence them. 

Term structure, yield curve, and expectations are important factors related to market rates, liquidity business cycles, and monetary policy. The expectation hypothesis (EH) can be divided into pure or unbiased.

It explains the movement of long-term interest rates by the market expectations for future short-term rates. 

To maximize the discount related to certain assets, investors select an optimum portfolio like – purchasing and consecutive holding the bonds whose maturity equals the planned venture duration, rolling over the short-term instrument or purchasing long-term and selling before maturity.

Policymakers believe it is easy to make short-term predictions, but the forecasting federal funds rates are based on target 1994. 

In the case of EH, the expectations related to future interest rates play a significant role in determining the portfolio and the term structure of rates.

Depending on the explanatory power of the involved factors, the theory can be classified as unbiased.

There has been opposition to the theory. Economists Shiller (1979) derived inequality restrictions that could be expressed as upper bound on the variance of the expected holding period yield as a function of the variance of short-term interest rate, and Singleton (1980) considered the bounds on the variance of long-term rates and found the upper bound on the variance was violated by maturity.