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 simply equal to the summation of current market expectations of future rates, but are biased by other factors. It can be contrasted to the pure expectations theory (also called the unbiased expectations theory) that says they are, and the long-term interest rates simply 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 explains the term structure of interest rates as a function of investor liquidity preference and the preferred habitat theory explains it as a result of a partially segmented market for bonds for various maturities. Both of these theories help to explain the normal observed term structure with an upward sloping yield curve. 

Understanding Biased Expectations Theory

Proponents of the biased expectations theory argue that the shape of the yield curve is influenced by systematic factors other than the market's current expectations of future interest rates. In other words, the yield curve is shaped from market expectations about future rates and also from other factors that influence investors’ preferences over bonds with different maturities. 

If long-term interest rates are determined solely by current expectations of future rates, then an upward sloping yield curve would imply that investors expect short-term rates to rise in the future. Because under normal conditions, the yield curve does indeed slope upward, this further implies that investors consistently seem to expect short-term rates at any given point in time. 

Yet this does not actually seem to be the case, and it is not clear why they would, or why they would not eventually adjust their expectations once proven wrong. Biased expectations theory is an attempt to explain why the yield curve usually slopes upward in terms of investor preferences.

Two common biased expectation theories are the liquidity preference theory and the preferred habitat theory. The liquidity preference theory suggests that long-term bonds contain a risk premium and the preferred habitat theory suggests that the supply and demand for different maturity securities are not uniform and therefore rates are determined somewhat independently over different time horizons.

Liquidity Preference Theory

In simple terms, the liquidity preference theory implies that investors prefer and will pay a premium for more liquid assets. In other words, they will demand a higher return for a less liquid security and will be willing to accept a lower return on a more liquid one. Thus, the liquidity preference theory explains the term structure of interest rates as a reflection 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 on longer maturity terms and the average of expected future rates on short-term bonds of the same total time to maturity. Forward rates, then, reflect both interest rate expectations and a liquidity premium which should increase with the term of the bond. This explains why the normal yield curve slopes upward, even if future interest rates are expected to remain flat or even decline a little. Because they carry a liquidity premium, forward rates will not be an unbiased estimate of the market expectations of future interest rates.

According to this theory, investors have a preference for short investment horizons and would rather not hold long term securities which would expose them to a higher degree of interest rate risk. To convince investors to purchase the long-term securities, issuers must offer a premium to compensate for the increased risk. The liquidity preference theory can be seen in the normal yields of bonds in which longer term bonds, which typically have lesser liquidity and carry a higher interest rate risk than shorter term bonds, have a higher yield to incentivize investors to purchase the bond.

Preferred Habitat Theory

The preferred habitat theory postulates 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. Instead the markets for bonds of different maturities are partially segmented, with supply and demand factors that act somewhat independently. However, because investors can move between them and buy bonds outside of their preferred habitat, they are related.

In other words, bond investors generally prefer short-term bonds and will not opt for a long-term debt instrument over a short-term bond with the same interest rate. Investors will be willing to purchase a bond of a different maturity only if they earn a higher yield for investing outside their preferred habitat, that is, preferred maturity space. However, bondholders may prefer to hold short-term securities due to reasons other than the interest rate risk and inflation.