what is expectations theory 
expectations theory attempts to predict what short term interest rates will be in the future based on current long term interest rates the theory suggests that an investor earns the same interest by investing in two consecutive one year bond investments versus investing in one two year bond today the theory is also known as the unbiased expectations theory investopedia jessica olahunderstanding expectations theorythe expectations theory aims to help investors make decisions based upon a forecast of future interest rates the theory uses long term rates typically from government bonds to forecast the rate for short term bonds in theory long term rates can be used to indicate where rates of short term bonds will trade in the future let s say that the present bond market provides investors with a two year bond that pays an interest rate of 20 while a one year bond pays an interest rate of 18 the expectations theory can be used to forecast the interest rate of a future one year bond in this example the investor is earning an equivalent return to the present interest rate of a two year bond if the investor chooses to invest in a one year bond at 18 the bond yield for the following year s bond would need to increase to 22 for this investment to be advantageous expectations theory aims to help investors make decisions by using long term rates typically from government bonds to forecast the rate for short term bonds disadvantages of expectations theoryinvestors should be aware that the expectations theory is not always a reliable tool a common problem with using the expectations theory is that it sometimes overestimates future short term rates making it easy for investors to end up with an inaccurate prediction of a bond s yield curve another limitation of the theory is that many factors impact short term and long term bond yields the federal reserve adjusts interest rates up or down which impacts bond yields including short term bonds 1 however long term yields might be less affected because many other factors impact long term yields including inflation and economic growth expectations as a result the expectations theory does not consider the outside forces and fundamental macroeconomic factors that drive interest rates and ultimately bond yields expectations theory versus preferred habitat theorythe preferred habitat theory takes the expectations theory one step further the theory states that investors have a preference for short term bonds over long term bonds unless the latter pay a risk premium in other words if investors are going to hold onto a long term bond they want to be compensated with a higher yield to justify the risk of holding the investment until maturity the preferred habitat theory can help explain in part why longer term bonds typically pay out a higher interest rate than two shorter term bonds that when added together result in the same maturity 