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

A risk analyst notes that the yield curve is upward sloping at all maturities. Under the pure expectations hypothesis (ignoring risk premium and convexity), which interpretation is correct?

Under the pure expectations hypothesis, forwards equal expected future short rates, so an upward sloping curve means the market expects short-term rates to rise. Risk premiums and convexity are assumed to be zero, so the slope reflects only rate expectations.

  1. AInvestors expect short-term rates to rise in the futureCorrect
  2. BInvestors demand compensation for interest rate volatility only
  3. CLong-term bonds have lower expected returns than short-term bonds
  4. DConvexity effects must be dominating the curve

Explanation

Under the pure expectations hypothesis, forward rates equal expected future spot rates, so an upward sloping curve implies that short rates are expected to rise. Risk premium and convexity are assumed absent, so options about volatility compensation or convexity do not apply. Expected returns are equal across maturities, so the third option is wrong.

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