Skip to content

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

A risk manager notes that the one-year forward rate for year two has consistently exceeded the realized one-year spot rate a year later. Which interpretation is most consistent with this observation?

Forwards persistently above later realized spot rates indicate that forward rates embed a positive risk premium over expected future rates. This contradicts the pure expectations hypothesis, which implies no systematic bias, so long-term investors earned compensation for bearing rate risk.

  1. AForward rates contain a positive risk premium over expected future spot ratesCorrect
  2. BThe pure expectations hypothesis holds exactly
  3. CConvexity makes forwards lower than expected rates
  4. DExpected spot rates were systematically above forwards

Explanation

If forwards persistently exceed realized spot rates, they are upward-biased predictors, consistent with a positive term premium compensating investors for interest-rate risk. Pure expectations would imply no systematic bias. Convexity would push forwards down rather than up.

Did you get it right without looking?

One question tells you little. A timed set on Expectations, Risk Premium, Convexity and the Shape of the Term Structure shows your real accuracy, how long you take and where you lose marks.

Practise Expectations, Risk Premium, Convexity and the Shape of the Term StructureFree diagnostic mock

More Expectations, Risk Premium, Convexity and the Shape of the Term Structure questions