Expectations theory is a strategy used by investors to predict future interest rate performance by evaluating current interest rates over the long term. While some believe in its merit, others argue that it is flawed and should be used in conjunction with other strategies. The theory can be too simple and miss important data, and it does not take into account the element of risk or reinvestment. It can be useful as a means of verifying predictions made using a broader base of factors.
Also known as a theory of expectation, a theory of expectation is a strategy that investors use to make predictions about future interest rate performance. Essentially, expectations theory states that by evaluating current interest rates over the long term, it is possible to determine the course of interest rates in the short term. While there are several supporters of this theory, many investors and financial experts also believe that the logic behind an expectations theory is flawed and does not serve as an accurate indicator of near-term future rates by itself.
For those who believe that the concept of expectancy theory has merit, it is often noted that many investment strategies rely on evaluating past movements to predict future performance. Since this approach has proven successful in helping choose sensible investments such as stocks and commodities, the same approach can also be used to predict short-term interest rate movement. Often, proponents of the theory will also point to anecdotal evidence that seems to support this approach.
Detractors sometimes note that while the idea behind expectancy theory can be useful in predicting future moves, it cannot accomplish the task of making accurate projections without collaboration with other resources. In other words, the expectation theory is fine when used as a factor in making an investment decision, but it is very likely to lead to false projections when used alone. For this reason, detractors often urge that the theory be used in conjunction with other strategies, or not at all.
One of the dangers inherent in expectation theory is that it can be too simple to overestimate short-term future rates. Since the theory is based only on looking at past long-term interest rate performance, this approach can easily miss data that is likely to dampen the amount of change in short-term interest rates. Factors such as political changes, disaster situations, or sudden changes in consumer tastes and demands can easily affect the direction of interest rates and skew the projections developed by using this theory.
The expectation theory also does not take into account the element of risk that can also influence the level of interest rates in general. For example, the theory does not recognize the fact that forward rates do not always provide a clear picture of future rates, a situation that makes the risk of investing in short-term rather than long-term bond issues more something bigger. The theory also does not include the possibility of reinvestment and therefore introduces a new factor that can have a dramatic impact on interest rates.
In general, expectancy theory is not considered the most reliable approach on its own. However, it can sometimes be useful as a means of verifying predictions made using a broader base of factors. This is because considering the state of long-term interest rates along with these other factors can help minimize the margin of error that would exist if rates were excluded from consideration entirely.
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