The expectations hypothesis suggests that long-term interest rates are determined by short-term expectations plus a fixed amount to reflect increased risk. However, most tests do not confirm this, and the reasons are disputed. The hypothesis is a starting point for an economic puzzle, and some studies suggest it becomes more accurate as the period of long-term rates increases.
The expectations hypothesis is a theory about how markets determine long-term interest rates on debt-based assets. The theory is simply that rates are decided by short-term expectations plus an additional fixed amount to reflect the inherent increased risk in the longer term. Most tests of the expectations hypothesis do not confirm this, but the reasons for this are disputed.
This assumption covers interest rates, which can be viewed from two perspectives. These are the interest rates that investors will receive by purchasing an asset. In turn, they are also the interest rates that the original issuer of the asset, such as a corporation or government, must pay to borrow in this way.
In most cases, the expectations hypothesis is not so much a forecasting tool as a way of telling what the relationship between known rates should be. Generally, the short-term and long-term rates of a specific asset, or different forms of the same asset, such as a 1-year bond and a 3-year bond, are already known. This means that we can immediately tell whether the expectations hypothesis is correct.
The precise formula used in an expectations hypothesis varies from case to case. There is a consistent principle that short-term and long-term rates vary according to a fixed level. The rationale is that all factors that affect the short-term rate apply to the long-term rate, but that the long-term rate also includes a “premium” to cover uncertainty, for example, the longer period of time during which the issuer may default.
As many studies show that the expectations hypothesis is not confirmed by reality, its main function is the starting point for an economic puzzle. Economists believe that figuring out why the hypothesis is not confirmed can help explain more about how markets really work. One theory is that while the basic reasoning of the expectations hypothesis is valid, the “premium” is not consistent and instead changes over time, possibly at varying rates. Another theory is that the hypothesis falsely assumes that it is possible to accurately predict short-term rates, when in reality there are too many variable factors at play to do so.
There are some studies that suggest that the hypothesis becomes more accurate as the period of long-term rates increases. At first glance, this might seem counterintuitive, as there are more opportunities for variation. In practice, it may be that a longer period gives more time for market imperfections to correct and investors to gather additional information, which means that demand and supply are equalized to produce a more predictable interest rate.
Asset Smart.
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