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In the last section we saw that the shape of the yield curve depends primarily on two factors: (1) expectations about future in?ation and (2) the relative riskiness of securities with different maturities. We also saw how to calculate the yield curve, given in?ation and maturity-related risks. In practice, this process often works in reverse: Investors and analysts plot the yield curve and then use information embedded in it to estimate the market’s expectations regarding future in?ation and risk.

This process of using the yield curve to estimate future expected interest rates is straightforward, provided (1) we focus on Treasury securities, and (2) we assume that all Treasury securities have the same risk; that is, there is no maturity risk premium. Some academics and practitioners contend that this second assumption is reasonable, at least as an approximation. They argue that the market is dominated by large bond traders who buy and sell securities of different maturities each day, that these traders focus only on short-term returns, and that they are not concerned with risk. According to this view, a bond trader is just as willing to buy a 30-year bond to pick up a short-term pro?t as he would be to buy a three-month security. Strict proponents of this view argue that the shape of the yield curve is therefore determined only by market expectations about future interest rates, and this position has been called the pure expectations theory of the term structure of interest
rates.

The pure expectations theory (which is sometimes called the “expectations theory”) assumes that investors establish bond prices and interest rates strictly on the basis of expectations for interest rates. This means that they are indifferent with respect to maturity in the sense that they do not view long-term bonds as being riskier than short-term bonds. If this were true, then the maturity risk premium (MRP) would be zero, and long-term interest rates would simply be a weighted average of current and expected future short-term interest rates. For example, if 1-year Treasury bills currently yield 7 percent, but 1-year bills were expected to yield 7.5 percent ayear from now, investors would expect to earn an average of 7.25 percent over the next two years.

7 % + 7.5 % = 7.25 %

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Taken From : Five-Minute MBA – Corporate Finance

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