Unbiased Expectation Hypothesis (UEH)

Unbiased Expectation Hypothesis

Current interest rates (yields on long-term bonds) reflect expectations of future interest rates (yield on -short-term bonds).

In human terms, UEH implies that both investment strategies (buying a 1 year bond each year, or buying a 10 year bond) is expected to have the same return.

We can thus calculate what the market expects future interests rate to be:

$$\begin{array}{rl}(1+r_{0,2}{)}^2& =(1+r_{0,1}{)}^1\times (1+E(r_{1,2}){)}^2\\ \Rightarrow E(r_{1,2})& =\frac{(1+r_0,2{)}^2}{(1+r_{0,1}{)}^1}-1\\ \Rightarrow E(r_{1,2})& =4.2\%\end{array}$$