Investments, tenth edition

   The Expectations Hypothesis 

 The simplest theory of the term structure is the    expectations  hypothesis    .  A common ver-

sion of this hypothesis states that the forward rate equals the market consensus expecta-

tion of the future short interest rate; that is,  f  

2

   5   E ( r  

2

 ), and liquidity premiums are zero. 

If  f  

2

   5   E ( r  

2

 ), we may relate yields on long-term bonds to expectations of future interest 

rates. In addition, we can use the forward rates derived from the yield curve to infer market 

expectations of future short rates. For example, with (1  1   y  

2

 ) 

2

   5  (1  1   r  

1

 )  3  (1  1   f  

2

 )  from 

Equation 15.5, if the expectations hypothesis is correct we may also write that (1  1   y  

2

 ) 

2

   5  

(1  1   r  

1

 )  3  [1  1   E ( r  

2

 )]. The yield to maturity would thus be determined solely by current 

and expected future one-period interest rates. An upward-sloping yield curve would be 

clear evidence that investors anticipate increases in interest rates. 

 If the expectations hypothesis is valid, what can we conclude about the  premiums 

necessary to induce investors to hold bonds of different maturities from their 

investment horizons? 

 CONCEPT CHECK 

15.6 

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7/17/13   4:03 PM

7/17/13   4:03 PM

Final PDF to printer

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498

   By the way, nothing limits us to nominal bonds when using the expectations hypothesis. 

The nearby box points out that we can apply the theory to the term structure of real 

interest rates as well, and thereby learn something about market expectations of coming 

inflation rates.