Expectations Theory of Interest
A theory that purports
to explain the shape of the yield curve, or the term structure of interest
rates. The forces that determine
the shape of the yield curve have been widely debated among academic economists
for a number of years. The
American economist Irving Fisher advanced the expectations theory of interest
rates to explain the shape of the curve.
According to this theory, longer-term rates are determined by investor
expectations of future short-term rates.
terms, the theory suggests that:
(1 + R2)2
= (1 + R1)
x (1 + E(R1))
the rate on two-year securities,
the rate on one-year securities,
the rate expected on one-year securities one year from now.
The left side of
this equation is the amount per dollar invested that the investor would
have after two years if he invested in two-year securities.
The right side shows the amount he can expect to have after two
years if he invests in one-year obligations.
Competition is assumed to make the left side equal to the right
The theory is easily
generalized to cover any number of maturity classes.
And however many maturity classes there may be, the theory always
explains the existence of longer-term rates in terms of expected future
theory of interest rates provides the theoretical basis for the use of
the yield curve as an analytical tool by economic and financial analysts.
For example, an upward-sloping yield curve is explained as an indication
that the market expects rising short-term rates in the future.
Since rising rates normally occur during economic expansions, an
upward-sloping yield curve is a sign that the market expects continued
expansion in the level of economic activity.
sometimes use this equation to obtain a market-related forecast of future
interest rates. It can be
rewritten as follows:
= [(1 + R2)2
/ (1 + R1)]
The equation suggests
that the short-term rate expected by the market next period can be obtained
from knowledge of rates today.