Pure expectations theory

Pure expectations theory

A theory that asserts that forward rates exclusively represent the expected future rates. In other words, the entire term structure reflects the market's expectations of future short-term rates. For example, an increasing slope to the term structure implies increasing short-term interest rates. Related: Biased expectations heories.

Pure Expectations Theory

In foreign exchange, a theory that forward exchange rates for delivery at some future date are equal to the spot rates for that date. The theory only functions in the absence of a risk premium. Critics contend that the evidence shows that pure expectations do not occur in actual trading.
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The pure expectations theory occurs when there are no k terms, so that [R.sup.L.sub.t] = (1 - [beta]) [summation over ([infinity]/j=0)][[beta].sup.j][E.sub.t][R.sub.t+j].
Implication for permanent changes in interest rates: Notably, the pure expectations theory predicts that if interest rates increase at date tin a manner which agents expect to be permanent, then there is a one-for-one effect of such a permanent increase on the level of the long rate because the weights sum to one, i.e., (1 - [beta]) [summation over ([infinity]/j=0)][[beta].sup.j] = (1 - [beta])/(1 - [beta]) = 1.
While these three implications can easily be derived under the pure expectations theory, they carry over to other more general theories so long as the changes in interest rates do not effect (1 - [beta]) [summation over ([infinity]/j=0)][[beta].sub.j][E.sub.t][k.sub.t+j] in (2).
The pure expectations theory of the term structure exposited by Fisher (1896), and refined by Lutz (1940) and Meiselman (1962), views forward rates as unbiased predictors of future short-term interest rates.