The Risk and Term Structure of Interest Rates - Term Structure of Interest Rates - Expectations theory
3 important questions on The Risk and Term Structure of Interest Rates - Term Structure of Interest Rates - Expectations theory
What is the common sense proposition on the expectations theory?
The interest rate on a long-term bond will equal an average of the short term interest rates that people expect to occur over the life of the long-term bond. (only if continuous rates are used)
What is the key assumption of the expectations theory?
Buyers of bonds do not prefer bonds of one maturity over another; they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity.
Or: Bond holders consider bonds with different maturities to be perfect substitutes.
Or: Bond holders consider bonds with different maturities to be perfect substitutes.
What does the expectations theory explain?
- Why the term structure of interest rates changes at different times
- Why interest rates on bonds with different maturities move together over time[fact1]
- Why yield curves tend to slope up when short-term rates are low and slope down when short-term rates are high [fact 2] ( see the calculation up as an illustration)
-> ≠ Cannot explain why yield curves usually slope upward [fact 3]
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