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FRM Part II · FRM Exam Part II · Expectations, Risk Premium, Convexity and the Shape of the Term Structure

A portfolio manager notes that the term structure is steeply upward sloping while survey-based expectations imply short rates will stay roughly flat. Which interpretation is most consistent with the decomposition into expectations, risk premium and convexity?

With expected short rates flat, a steep upward slope is best explained by a positive term premium for bearing interest rate risk. Convexity pushes long yields down, so it partly offsets the premium rather than creating the slope.

  1. AThe slope is mainly driven by a positive term premium compensating for interest rate risk, partly offset by convexityCorrect
  2. BThe slope is mainly driven by convexity, which increases long-term yields
  3. CThe slope must reflect expected rate rises, since premiums are zero in equilibrium
  4. DThe slope is driven by the fact that forward rates are always lower than expected spot rates

Explanation

If expected short rates are flat, the upward slope must come from the term premium, since convexity lowers rather than raises long yields. Premiums are not zero when investors are risk averse, and forwards are generally not systematically below expected rates when premiums are positive.

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