Biased Expectations Theory

What is Biased Expectations Theory?

The biased expectations theory is a theory of the term structure of interest rates. In biased expectations theory forward interest rates are not just equivalent to the summation of current market expectations of future rates, however are biased by different factors. It tends to be differentiated to the pure expectations theory (likewise called the unbiased expectations theory) that says they are, and the long-term interest rates basically reflect expected short-term rates of equivalent total maturity. There are two major forms of biased expectations theory: the liquidity preference theory and the preferred habitat theory. The liquidity preference theory makes sense of the term structure of interest rates as a function of investor liquidity preference and the preferred habitat theory makes sense of it because of a to some degree segmented market for bonds for different maturities. Both of these hypotheses help to make sense of the normal noticed term structure with a vertical slanting yield curve.

Grasping Biased Expectations Theory

Advocates of the biased expectations theory contend that the state of the yield curve is influenced by systematic factors other than the market's current expectations of future interest rates. As such, the yield curve is formed from market expectations about future rates and furthermore from different factors that influence investors' preferences over bonds with various maturities.

On the off chance that long-term interest rates are determined exclusively by current expectations of future rates, then a vertical slanting yield curve would suggest that investors anticipate that short term rates should rise from now on. Since under normal conditions, the yield curve in all actuality does without a doubt slant up, this further suggests that investors reliably appear to anticipate short-term rates at some random point in time.

Yet this doesn't actually appear to be the case, and it isn't clear why they would, or why they wouldn't eventually change their expectations once proven wrong. Biased expectations theory is an endeavor to make sense of why the yield curve for the most part slants up in terms of investor preferences.

Two common biased expectation hypotheses are the liquidity preference theory and the preferred habitat theory. The liquidity preference theory proposes that long-term bonds contain a risk premium and the preferred habitat theory recommends that the supply and demand for various maturity securities are not uniform and accordingly rates are determined fairly freely throughout various time skylines.

Liquidity Preference Theory

In simple terms, the liquidity preference theory suggests that investors like and will pay a premium for additional liquid assets. All in all, they will demand a higher return for a less liquid security and will actually want to acknowledge a lower return on a more liquid one. Consequently, the liquidity preference theory makes sense of the term structure of interest rates as an impression of the higher rate demanded by investors for longer-term bonds. The higher rate required is a liquidity premium that is determined by the difference between the rate based on longer maturity conditions and the average of expected future rates on short-term bonds of a similar total chance to maturity. Forward rates, then, reflect both interest rate expectations and a liquidity premium which ought to increase with the term of the bond. This makes sense of why the normal yield curve inclines up, even on the off chance that future interest rates are expected to stay flat or even decline a bit. Since they carry a liquidity premium, forward rates won't be an unbiased estimate of the market expectations of future interest rates.

As per this theory, investors have a preference for short investment skylines and would prefer not to hold long term securities which would open them to a higher degree of interest rate risk. To persuade investors to purchase the long-term securities, issuers must offer a premium to make up for the increased risk. The liquidity preference theory should be visible in the normal yields of bonds in which longer term bonds, which commonly have lesser liquidity and carry a higher interest rate risk than shorter term bonds, have a higher yield to boost investors to purchase the bond.

Preferred Habitat Theory

The preferred habitat theory proposes that short-term bonds and on long-term bonds are not perfect substitutes, and investors have a preference for bonds of one maturity over another. Rather the markets for bonds of various maturities are somewhat segmented, with supply and demand factors that act fairly freely. Be that as it may, in light of the fact that investors can move among them and buy bonds outside of their preferred habitat, they are connected.

As such, bond investors generally favor short-term bonds and won't opt for a long-term debt instrument over a short-term bond with a similar interest rate. Investors will actually want to purchase a bond of an alternate maturity provided that they earn a higher yield for investing outside their preferred habitat, or at least, preferred maturity space. Notwithstanding, bondholders might like to hold short-term securities due to reasons other than the interest rate risk and inflation.

Features

• Biased expectations theory assists with making sense of why the term structure of interest rates normally incorporates a vertical slanting yield curve.
• Biased expectations theory has two major variations; liquidity preference theory and preferred habitat theory.
• Based expectations theory affirms that factors other than current expectations of future short-term interest rates influence current long-term interest rates.