What is Biased Expectations Theory?

The biased expectations theory states that the total of market expectations is equivalent to the future value of rates of interest. In terms of foreign exchange, it showcases that forward rates of exchange that are related to the delivery at some point in the future are equal to the spot rates for that very day, provided no risk premium is involved.

How Does Biased Expectations Theory Work?

The supporters of this theory say that the systematic variables are not considered at the time of formulating the yield curve. Also, they are of the view that the present market scenario solely influences the tenure of interest rates. This means that the yield curve is the result of market beliefs about prospective rates and larger premium amount that asks investors to make investment in long-term bonds. There are two generally used biased expectation theories namely the liquidity preference theory and the preferred habitat theory. As per the liquidity habitat theory, there is a certain risk premium associated with the bonds that have a bigger maturity period. The preferred habitat theory states that there is no consistency in the demand and supply of various maturity securities, which results in variation in risk premium for every single security.

How Does Liquidity Preference Theory Work?

The liquidity preference theory states that investors who are wishing to invest in liquid assets need to pay a specific premium for it. According to this theory, the investors prefer having more rates in the form of forward rates at the time of making investments in long-term bonds. By ascertaining the gap between the rate on maturity terms with a longer duration and the mean of predicted future rates, one can ascertain the liquidity premium. Forward rates that signify expected rates of interest and risk premium should rise as the time duration of the bond increases. This is a clear indicator of the normal yield curve sloping in an upward direction, in spite of the future rates of interest remaining constant or even falling a bit. Forward rates will offer a biased prediction of the expected future interest rates in the market since they have an element of risk premium. As per this theory, investors believe in going for short-term investments, and not long-term ones in order to save themselves from a larger extent of interest rate risk. Hence, it is essential for the issuing company to provide a premium amount on long-term securities to investors so as to reimburse them for risks involved. Normal yields of bonds exhibit liquidity theory. Here, long term bonds that are not much liquid and carry more interest rate risk tend to have more yield for influencing investors to buy the bond.

What is Preferred Habitat Theory?

Similar to the liquidity theory, the preferred habitat theory states that the yield curve is a reflection of the expected movements in future interest rates and risk premium. Though this theory doesn't support the idea of raising risk premium for longer maturity terms. This theory states that there are no exact substitutes for short-term and long-term bonds interest rates. Also, investors prefer bonds with one maturity period over the other. It means that bond investors go for a specific market segment depending on the tenure or the yield curve, and would rather invest in a short-term bond over the long-term one with similar rates of interest. Investors will only consider buying a bond of a distinct maturity, provided they are given assurance of earning more yield for making investment outside their comfort zone or in this case, feasible maturity space. For example, bondholder who buys short-term bonds considering interest rate risk and the effects of inflation on long-term bonds will go for long-term bonds if he or she receives a significant amount of yield incentive on his or her investment.