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Expectations theory

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asked Aug 18 in BUS 4027W - Actuarial Risk Management by rohin_jain (640 points)

For expectations theory in the yield curves:

Do investors expect a higher level of future inflation in the future which makes them demand a higher yield at longer terms to maturity. Or do they expect a higher interest rate in the future terms which means them demand a higher return for long-dated bonds.

I think that perhaps a high interest rate is there to combat the rising inflation? So does it not make sense that the investor expects a high level of inflation in the future. To which the Reserve Bank increases interest rate (in attempt to reduce impact of inflation).  

1 Answer

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answered Aug 22 by ErichMaritz (500 points)

Market participants might have short-term inflation expectations (and short-term interest expectations), based on what they see happening in the economy. This goes out to (say) two to three years.

For the longer term, expected inflation would depend more on investors' belief in the reserve bank's ability to keep inflation within their target band. I do not think that expected inflation for the period 5-10 years would be different from the period 10-15 years. It might be 6% or 5.5% for both. So, on a pure expectations theory, I cannot argue for a increasing yield curve.

However, the inflation risk premium would be increasing. While these two periods might have the same expected value, their variance (if we think of actual inflation as a stochastically modelled variable) would be increasing, to a limiting value. Think back to Fin Eco's where a mean-reverting yield had a time-dependent variance with a limiting value. Applying the idea of a "price of risk", the inflation risk premium would be increasing.

The above can be re-phrased in terms of the expectations theory for cash rates, where the liquidity premium would be increasing.