Local Expectations Theory

The Local Expectations Theory is an economic theory related to the term structure of interest rates. It suggests that the shape of the yield curve, which represents the relationship between interest rates and the maturity of debt securities, is determined by investors' expectations of future short-term interest rates.

The theory's focus on expectations of future short-term interest rates makes it relevant for interest rate forecasting. By understanding and incorporating these expectations, investors can gain insights into the direction of interest rates. It can aid in decision-making related to bond investments, loan pricing, and overall portfolio management.

• Local expectations theory centers around the interplay between short-term and long-term interest rates. 
• This theory posits that bonds with extended maturities may fail to compensate investors for short-term interest or reinvestment rate risks adequately.
• This theory emphasizes short-term yield impacts, while Pure Expectations Theory considers the entire term structure, incorporating both short and long-term interest rates.
• It assumes that market expectations of future short-term interest rates play a pivotal role in determining bond returns, particularly over shorter investment horizons.

Local expectations theory focuses on short-term investment periods and implies that the returns of bonds with different maturities will be equivalent over such a period. According to the theory, the returns on bonds are determined by the market's expectations of short-term interest rates. In the case of two bonds with different maturities, such as a 5-year bond and a 10-year bond, the theory suggests that both bonds will provide similar returns over a short-term investment horizon (e.g., six months).

The rationale is that the theory assumes that forward rates, representing market expectations of future short-term interest rates, accurately reflect the future interest rate environment. Therefore, the theory suggests that regardless of the bond's maturity, its return over a short period will be comparable because the market expectations for short-term rates are consistent.

The theory also suggests that the returns of longer-term bonds do not compensate investors for interest or reinvestment rate risk. Interest rate risk also refers to the potential for bond prices to decline as interest rates rise. In contrast, reinvestment rate risk relates to the uncertainty of reinvesting coupon payments at favorable rates. The theory, in this context, implies that investors will not receive additional compensation for taking on these risks when investing in longer-term bonds.

Let us look at the examples to understand the concept better.

Example #1

Let us consider an investor named Sarah, who is evaluating two bonds: Bond A and Bond B. Bond A has a maturity of 5 years, while Bond B has a maturity of 10 years. Both bonds have identical coupon rates and credit ratings.

Based on the theory, Sarah expects that the returns of Bond A and Bond B will be equivalent over a short-term investment period, such as six months. This expectation is driven by the theory's assumption that the market's expectations of future short-term interest rates will determine the returns of the bonds.

Suppose Sarah invests her money for six months and purchases Bonds A and B. At the time of the investment, the market expects short-term interest rates to remain relatively stable during the six months.

Over the investment horizon, if the market's expectations prove to be accurate and short-term interest rates remain stable, Sarah would observe that the returns on Bond A and B are indeed similar. This outcome aligns with the theory, which posits that the returns of bonds with different maturities over a short-term period should be comparable.

However, it is important to note that if the market's expectations regarding short-term interest rates change during the investment period, the actual returns on bonds A and B may deviate. In such a scenario, the theory may not hold precisely, and the returns of the two bonds could diverge.

Example #2

Let us consider another situation where a country's central bank has recently lowered its short-term interest rates in response to a sluggish economy. Market participants, including investors and financial institutions, closely monitor these rate changes and form expectations about future interest rate movements.

In this scenario, suppose an investor named Mark is considering two bonds: Bond X and Bond Y. Bond X has a maturity of 3 years, while Bond Y has a maturity of 8 years. Both bonds have the same credit rating and coupon rate.

Based on the theory, Mark considers the market's expectations of future short-term interest rates when evaluating Bond X and Y's potential returns. The theory suggests that if market participants expect short-term interest rates to remain low or decrease further over the short term, the returns on both bonds should be similar over that period.

In this case, market expectations align with the theory, and many investors anticipate that the central bank will maintain or reduce interest rates to stimulate the economy. As a result, Mark believes that the returns on Bond X and Y will be comparable over the short term.

Mark decides to invest his money for six months, expecting short-term interest rates to remain stable or decline slightly. He purchases Bond X and Bond Y accordingly.

Over the six-month investment horizon, if the market expectations are realized and short-term interest rates remain stable or decrease slightly, Mark would observe that the returns on Bond X and Y are similar. This outcome supports the theory, where the returns on bonds with different maturities converge when market expectations of short-term interest rates align.

The differences between the local expectations theory and pure expectations theory are as follows- 

1. The local expectations theory focuses on short-term investment periods, typically within a year or even shorter. It suggests that the returns of bonds with different maturities will be equivalent over such a period. In contrast, the pure expectations theory is not limited to a specific time horizon. It assumes that long-term interest rates are an average of expected future short-term rates for each period of the bond's maturity.
2. The local expectations theory does not make explicit predictions about the shape of the yield curve, as it primarily considers short-term interest rate expectations. Conversely, the pure expectations theory provides a more comprehensive view and suggests that the shape of the yield curve reflects the market's expectations of future short-term interest rates. It predicts an upward-sloping yield curve when short-term rates are expected to rise and a downward-sloping yield curve when short-term rates are expected to decline.
3. The local expectations theory does not explicitly incorporate compensation for interest or reinvestment rate risk when comparing bonds of different maturities. It assumes that longer-term bonds do not provide additional compensation for these risks. In contrast, the pure expectations theory acknowledges that investors may require compensation for interest rate risk and reinvestment rate risk when holding longer-term bonds, and it factors these risks into the yield curve.

This article has been a guide to what is Local Expectations Theory. Here, we explain the concept along with its examples & differences with pure expectations theory. You may also take a look at the useful articles below –

• Biased Expectations Theory
• Unbiased Expectations Theory
• Expectations Theory