Local Expectations Theory

One branch of traditional term structure theory focuses on interpreting term structure shape in terms of investors’ expectations. Historically, the first such theory is known as the unbiased expectations theory or pure expectations theory. It says that the forward rate is an unbiased predictor of the future spot rate; its broadest interpretation is that bonds of any maturity are perfect substitutes for one another. For example, buying a bond with a maturity of five years and holding it for three years has the same expected return as buying a three-year bond or buying a series of three one-year bonds.

The predictions of the unbiased expectations theory are consistent with the assumption of risk neutrality. In a risk-neutral world, investors are unaffected by uncertainty and risk premiums do not exist. Every security is risk free and yields the risk-free rate for that particular maturity. Although such an assumption leads to interesting results, it clearly is in conflict with the large body of evidence that shows that investors are risk averse.

A theory that is similar but more rigorous than the unbiased expectations theory is the local expectations theory. Rather than asserting that every maturity strategy has the same expected return over a given investment horizon, this theory instead contends that the expected return for every bond over short time periods is the risk-free rate. This conclusion results from an assumed no-arbitrage condition in which bond pricing does not allow for traders to earn arbitrage profits.

The primary way that the local expectations theory differs from the unbiased expectations theory is that it can be extended to a world characterized by risk. Although the theory requires that risk premiums be nonexistent for very short holding periods, no such restrictions are placed on longer-term investments. Thus, the theory is applicable to both risk-free as well as risky bonds.

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