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Definition: Pure Expectation Theory
Pure expectation theory explains the term structure in terms of expected future short- term interest rates. According to expectation theory the yield on a two- year bond is set by the market in such a way that the return of the two year bond is approximately equal to the return on a one-year bond plus the expected return on a one year bond purchased one year from today.
Under this theory, if the yield on the two year bond is higher than the one year bond, then the investor expects that the yield on one year bond from a year now will be sufficiently higher than the one-year rate available now so that the two ways of investing for two years have the same expected return. i.e
One-year bond rate + One-year bond rate one year later = Two year bond rate
So as a result,
We can invest in bonds for two years in the following ways:
i) Buy a bond which will mature after two years from now
ii) Buy a one-year bond that will mature after one year from now. When the first bond matures after one year from now buy another one-year bond.
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