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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 yield curve is inverted at the long end even though the central bank is expected to hold short rates constant, and the term premium is estimated to be near zero. Which driver best explains the downward slope at long maturities?

Convexity best explains the inversion. With flat expected short rates and no term premium, the only remaining force is the convexity effect, which lowers long-maturity yields more as maturity and volatility rise, bending the long end of the curve downward.

  1. AA large positive risk premium for duration risk
  2. BConvexity, which lowers long-term yields and becomes more important as volatility and maturity increaseCorrect
  3. CExpectations of rising future short rates
  4. DLiquidity preference theory, which implies forwards exceed expected rates

Explanation

With flat expectations and no term premium, the remaining driver is convexity, which reduces long-maturity yields and grows with maturity and volatility, potentially bending the curve down. A positive risk premium or rising expectations would slope the curve up.

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