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FRM Part I · FRM Exam Part I · Interest Rates

A bank analyst observes a persistently upward-sloping yield curve. Which interpretation is consistent with the liquidity preference theory but NOT required by the pure expectations theory?

The liquidity preference theory interprets an upward slope as including a positive term premium that compensates investors for the greater price risk of long-term bonds. Pure expectations has no premium, so slope arises only from expected rate rises. Market segmentation instead relies on maturity-specific investor preferences.

  1. AInvestors expect short-term rates to rise, and nothing else affects long-term yields
  2. BLong-term yields include a positive term premium that compensates investors for greater price riskCorrect
  3. CInvestors and borrowers are confined to specific maturities and never switch
  4. DForward rates must equal expected future spot rates exactly

Explanation

Liquidity preference theory says forward rates exceed expected future spot rates by a positive liquidity (term) premium, because investors demand compensation for holding longer-maturity bonds. Pure expectations assumes no such premium, so forward equals expected spot. The segmentation description and the exact-equality statement belong to other theories.

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