Expectations Hypothesis

The expectations hypothesis is a theory stating that long-term interest rates are determined by the market's expectation of future short-term interest rates. It assumes that investors are indifferent between holding a long-term bond or a sequence of short-term bonds, provided the total return is the same.

This hypothesis provides a framework for interpreting the shape of the yield curve and predicting future rate moves. While it is a useful conceptual tool, it often ignores risk premiums that investors demand for holding longer-term assets.

In reality, the yield curve is influenced by both expectations and the term premium. Traders use this hypothesis as a starting point for developing their interest rate views and hedging strategies.

It remains a cornerstone of traditional economic theory in finance.