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

A risk manager is reviewing a government yield curve that is upward sloping. Under the pure expectations hypothesis, which statement best describes how the slope should be interpreted?

Under the pure expectations hypothesis there is no risk premium, so forward rates equal expected future spot rates. An upward-sloping curve therefore signals only that the market expects short-term rates to rise, not that investors require compensation for bearing term risk.

  1. AInvestors demand extra compensation for holding longer-maturity bonds, so the slope reflects a term premium
  2. BThe slope reflects only the market's expectation of higher future short-term ratesCorrect
  3. CThe slope reflects only the convexity of long-maturity bond prices
  4. DThe slope shows that long bonds have lower expected returns than short bonds

Explanation

The pure expectations hypothesis assumes risk premiums are zero, so forward rates equal expected future short rates. An upward slope then means only that higher short rates are expected. The term premium explanation belongs to preferred-habitat or liquidity-premium views, not the pure hypothesis.

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