This assumption holds that the slope of the curve is due to changes in short-term interest rate expectations. The higher yield of long-term bonds reflects the expectation of rising future yield, while the lower yield of long-term bonds (downward sliding or reverse yield curve) reflects the expectation of falling short-term interest rates.
One implication of the expectation hypothesis is that the expected holding rate of all bonds due should be equal. Even if the yield curve inclines upwards (so the yield to maturity of two-year bonds is higher than that of one-year bonds), it does not necessarily mean that investors expect higher yield of two-year bonds. As we have seen, it is necessary to have a higher yield to maturity for the initial two-year bonds, because it can make up for the risk that investors will pursue higher yields in the next year. After the end of the two-year period, even after the end of any holding period, the theory predicts that the holding period yield of all maturing bonds will be equal.
The expectation hypothesis explains why the term structure of interest rates changes with time. If the yield curve inclines upward, it is because short-term interest rates are expected to rise in the future; If the yield curve is downward, it is because short-term interest rates are expected to fall in the future. Similarly, the flat yield curve appears because the short-term interest rate expectation remains unchanged, and the arched yield curve appears because the short-term interest rate expectation rises first and then falls.
The expectation hypothesis also explains why long-term interest rates change with short-term interest rates. Generally speaking, the short-term interest rate has a characteristic, that is, if the short-term interest rate level rises today, it will often be higher in the future. Therefore, raising the level of short-term interest rates will raise people's expectations of future short-term interest rates. Because the long-term interest rate is equivalent to the average of the expected short-term interest rate, the rise of the short-term interest rate level will also make the long-term interest rate rise, thus making the short-term interest rate change in the same direction as the long-term interest rate.
Expectation hypothesis, also known as pure expectation hypothesis, was first put forward by American economist irving fisher in 1986, and contemporary economists are still perfecting the theory of expectation hypothesis. At present, the theory of expectation hypothesis has been divided into several branches, such as incomplete expectation hypothesis, complete expectation hypothesis, institutional expectation hypothesis and error correction expectation hypothesis.