Question

Explain with reference to Expectation Theory that how interest rates vary across maturities.

Answer 1

Expectation theory is related to reflecting the expectation of investors in order to receive bond yield on various maturity and it will be a reflecting that yield curve will be representing the expectation of the investor to receive bond yield on various maturity of same class.

Expectation theory will be advocating that investor will normally expect higher bond yield for bonds with longer maturity and they will be expecting lower bond yield for bonds with lower maturity because they will be exposed to lower risk in shorter duration.

Expectation theory will also have significant role to play in the direction of the yield curve and when the yield curve will be upward-sloping, it will mean that investors are expecting a very high rate of bond yield for long-term securities whereas they are expecting lower Bond yields for short-term securities and it will be a representation of bullish economy and a growth economy.

inverted yield curve will also be reflecting the expectation theory which will reflect the expectation of an investor about the recession in the economy because the long term bond yield will be lower than the short term bond yield and it will mean that investors are expecting that in the long term they are not going to make much return out of investment in the debt instruments so they are expecting a recession in the economy.

Hence, it can be summarised that Expectations theory will be having a great role to play in the various cycles of the economy because it is representing the expectation of a large group of market participants.