A theory that the future value of interest rates is equal to the summation of market expectations. 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 biased expectations do not occur in actual trading. This is also called pure expectations theory.Proponents of the biased expectation theory argue that the shape of the yield curve is created by ignoring systematic factors and that the term structure of interest rates is solely derived by the market’s current expectations.
Two common biased expectation theories are the liquidity preference theory and the preferred habitat theory. The liquidity preference theory suggests that long-term bonds contain a risk premium and the preferred habitat theory suggests that the supply and demand for different maturity securities are not uniform and therefore there is a difference risk premium for each security.