What is an Expectation Theory?

Also known as an expectancy theory, an expectation theory is a strategy that is used by investors to make predictions about the future performance of interest rates. Essentially, the expectations theory states that by evaluating current long-term interest rates, it is possible to determine the course of short-term interest rates. While there are a number of supporters for this theory, many investors and financial experts also believe the logic behind a theory of expectations is flawed and does not serve as an accurate indicator of future short-term rates in and of itself.

For those that believe the concept of the expectation theory has merit, it is often noted that many investment strategies rely on evaluating past movements in order to predict future performance. Since this approach has proven successful in helping to choose wise investments such as stocks and commodities, the same approach can also be used in predicting the movement of short term interest rates. 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 the expectation theory may be helpful in predicting future movements, it cannot accomplish the task of making correct projections without collaboration using other resources. In other words, the expectation theory is fine when used as one factor in making an investment decision, but is highly likely to lead to false projections when used alone. For this reason, detractors usually urge that the theory be employed in conjunction with other strategies, or not used at all.

One of the inherent dangers with the expectation theory is that it can be very simple to overstate the estimate on the future short-term rates. Since the theory relies only on analyzing past performance of long-term interest rates, this approach can easily omit data that would possibly temper the amount of change in short term interest rates. Factors such as political shifts, disaster situations, or sudden changes in consumer tastes and demands can easily impact the direction of interest rates and throw the projections developed through the use of this theory out of line.

The expectation theory also does not take into account the element of risk that may also influence the level of interest rates in general. For example, the theory does not recognize the fact that forward rates don’t always provide a clear picture of future rates, a situation that makes the risk of investing in short term bonds rather than long-term bond issues somewhat higher. The theory also does not include the possibility of reinvestment taking place and therefore introducing a new factor that can have a dramatic impact on interest rates.

In general, the expectation theory is not considered the most reliable approach on its own. However, it can sometimes be helpful as a means of double checking the predictions made using a wider base of factors. This is because considering the status of long-term interest rates in tandem with these other factors can help to minimize the room for error that would exist if the rates were excluded from consideration altogether.