Question

Explain the Expectation Theory of the term structure of interest rates

Answer 1

The expectations theory explains the relationship between short- and long- term interest rates. As per the theory, the long term rates are entirely governed by the expected future path of short-term interest rates. This theory predicts what will be the short-term interest rates in the future based on current long-term interest rates The long-term rates are used to indicate at which rates of short-term bonds will trade in the future.

It also suggests that the interest earned by an investor by investing in one two-year bond today, will be equal to the interest earned by investing in two consecutive one-year bond investments. Thus, the expectations theory is also known as the "unbiased expectations theory." It helps the investors to make decisions by forecasting the future interest rates.