Pure Expectations Theory in Finance

Pure Expectations Theory

• The theory assumes that the current yield curve solely reflects investors' expectations of future short-term interest rates.
• It predicts future short-term rates (forward rates) based on current long-term rates.
• The yield curve shape is determined by the market's expectation of future short-term interest rates.
• If the market anticipates short-term rates will increase (decrease) in the future, the yield curve will slope upwards (downwards).

Yield Curve Shape

• Normal (Upward Sloping)
  • Short-term yields are lower than long-term yields.
  • Long-term bonds have higher yields compared to short-term bonds.
  • Indicates that investors expect stronger economic growth and potentially higher inflation in the future.
  • Higher returns for longer maturity bonds due to higher exposure to uncertainty of rate changes and inflation risk.
• Inverted (Downward Sloping)
  • Short-term bonds have higher yields compared to long-term bonds.
  • Indicates that investors expect slower economic growth or a recession in the future.
  • Investors prefer long-term bonds to lock in current yields, anticipating that interest rates will fall due to economic weakness.
  • Lower returns for having less exposure to uncertainty of rate changes and inflation risk.
• Flat Yield Curve
  • Rarely observed, only during economic changes, transitioning from upward to downward sloping or vice versa.

Discount Factors/Spot Rates/Forward Rates

• Discount Factor: determined from the market price and cashflows of a bond, used to obtain the corresponding spot rate and create a yield curve.
• Forward Rates: market expectations of interest rates in the future.
• Forward rates vs spot rates indicate what the market thinks will happen in the future.
• Bond Risk: short-term bonds have less interest rate risk, while long-term bonds are more sensitive to risk.

Arbitrage Opportunity - Negative Rates

• A negative forward rate implies mispricing.
• Buy under-priced bonds and sell over-priced bonds to take advantage of the arbitrage opportunity.

Interest Rates

• High Interest Rates: decrease in bond prices, providing an opportunity for investors.
• Low Interest Rates: increase in bond price, making them more valuable.

Other Theories

• Liquidity Preference Theory: investors are compensated for time, but get extra if they invest for longer, taking more risk.
• Market Segmentation Theory: investors will never change their preference, and supply and demand shift the yield for each market segment.
• Preferred Habitat Theory: investors have preferred time maturity to bonds, but may take other opportunities, considering investment duration, price risk, or tolerance.