FRM Part II · FRM Exam Part II · Expectations, Risk Premium, Convexity and the Shape of the Term Structure
A risk analyst observes that the forward rate curve is upward sloping, but survey evidence shows investors expect future short rates to stay flat at today's level. Which interpretation is most consistent with this observation?
The upward-sloping forward curve with flat expected short rates indicates a positive term premium. Investors demand extra compensation for the interest rate risk of long bonds, so forward rates exceed expected future spot rates. Pure expectations would imply a flat curve in this case.
- AForward rates embed a positive term premium compensating investors for bearing interest rate riskCorrect
- BConvexity is causing forward rates to be above expected rates by exactly the amount of the volatility
- CThe expectations hypothesis holds exactly, so forward rates equal expected future spot rates
- DInvestors are risk-seeking and pay a premium for long bonds
Explanation
If forwards exceed expected future short rates, the gap is a risk premium for holding longer-term bonds exposed to rate risk. Under exact expectations, forwards would equal expected rates, so the flat expectations would imply a flat curve. Risk-seeking investors would produce negative premiums and a lower forward curve.
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