This theory states that the yield curve depends on the expectation about future inflation rates. If inflation rate is expected to increase, then the rate on long-term bonds will exceed that of short-term loan. The expected future interest rates are equal to forward rates computed from the expectations with regard to future interest rates are. Other factors which affect the expectations with regard to future interest rates are:

  • Political stability

  • Monetary policy of the government

  • Fiscal policy of the government (government expedition)

  • Other economic related factors including social factors.

The following conditions are necessary for the expectation theory to hold.

i) Perfect capital markets exists where there are many buyers and sellers of security with non having a significant influence on the interest rates.

ii) Investors have homogeneous expectations about future interest rates and returns on all investments.

iii) Investors are rational wealth maximizers

iv) Bankruptcy of firms due to use of borrowing is unlikely.