More on Interest Rates

Using the Yield Curve to Estimate Interest Rates in the Future

Market Expectations (i.e. Pure Expectations)

When it comes to interest rates specifically, yield curves are useful constructs in projecting future behavior. The market expectations theory assumes that various maturities are perfect substitutes, and as a result the shape of the yield curve represents market expectations over time in relation to interest rates. In short, through investor expectations of what the 1-year interest rates will be next year, the current 2-year interest rate can be calculated as the compounding of this year’s 1-year interest rate by next year’s expected 1-year interest rate. Or, as an equation:

$\left(1+\mathrm{i}_{\mathrm{lt}}\right)^{\mathrm{n}}=\left(1+\mathrm{i}_{\mathrm{st}}^{\mathrm{year} 1}\right)\left(1+\mathrm{i}_{\mathrm{st}}^{\mathrm{year} 2}\right) \cdots\left(1+\mathrm{i}_{\mathrm{st}}^{\mathrm{year} \mathrm{n}}\right)$ ,

(i_st and i_lt are the expected short-term and actual long-term interest rates, respectively)