The Expectations Hypothesis, also known as the Pure Expectations Theory, posits that the return on a long-term bond is essentially the average return on short-term bonds over the same period. This theory asserts that expected future spot rates of interest are equal to the forward rates that can be calculated today. In other words, the forward rates are unbiased predictors for making expectations of future spot rates. Therefore, we can forecast future interest rates by looking at the term structure of interest rates.

The term structure of interest rates, also known as the yield curve, is a graphical representation that shows the relationship between interest rates (yields) and the time to maturity. By examining the shape of the yield curve (normal, inverted, flat, or humped), investors can infer market expectations about future interest rate movements.

Key points:

• Long-term rates represent the geometric average of expected future short-term rates
• Forward rates implied by the current term structure are unbiased estimators of future spot rates
• The shape of the yield curve provides information about market expectations of future interest rate movements
• The theory assumes no risk premium for holding longer-term bonds