In the debates: forward guidance (indications of future interest rate movements) and quantitative easing by the Fed (mass purchases of Treasury bonds and mortgage-backed securities) are hotly debated by both professionals and academics. The main purpose of these policies is to directly influence long-term interest rates. Here we shed light on the « expectation hypothesis, » a central hypothesis often implicitly cited in discussions of the mechanisms at work.
If we follow the hypothesis of rational agents and efficient markets, the expected return on a long-term bond must be equal to the expected return on a series of short-term bonds with a total maturity equal to that of the long-term bond.
In other words, it is the same to buy a bond with a maturity of ten years as it is to buy a bond with a maturity of one year and renew it every year for ten years (apart from the operational costs[1]). This equality, which defines the Expectation Hypothesis, has not been empirically verified and highlights the existence of a termpremium, equal to the difference between the return on the long-term bond and the product of the short-term bonds.
Finally, theExpectation Hypothesis can be reformulated as follows:
– the expected short-term interest rate must be equal to the corresponding forward rate; in other words, markets correctly anticipate interest rate movements and incorporate this information into prices.
Adrien T.
[1]In particular, this assumption does not take into account the risks associated with debtrollover.
