Expectations theory of interest rates — Accounting glossary

In its pure form, the theory relates the return from investing for a longer period to the return from rolling over shorter investments, with no additional term premium. For example, the two-year accumulation factor can be linked to today's one-year rate and the expected next one-year rate. In reality, risk premiums and market frictions can affect yields, so an implied forward rate is not necessarily an unbiased or certain future spot rate. The theory is one explanation of yield-curve shape, alongside liquidity preference and market segmentation.

Worked example

If today's one-year rate is 4% and next year's expected one-year rate is 6%, the pure-expectations two-year annual yield satisfies (1 + y)² = 1.04 × 1.06. Thus y is approximately 4.995%, rather than a guaranteed future one-year rate.

Common mistake

Reading a forward rate implied by today's curve as a certainty, or ignoring the theory's assumption about term premiums.

Where it appears in your exams

Qualification	Exam	Relationship	Period
ACCA	AFM	Supporting	September 2026–June 2027
ACCA	FM	Direct	September 2026–June 2027