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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 observes that an upward-sloping yield curve persists even though survey evidence suggests investors expect short-term rates to remain unchanged. Which explanation is most consistent with this observation under the decomposition of forward rates into expectations, risk premium, and convexity?

With expected short rates unchanged, a rising curve is explained by a positive term premium, the compensation investors require for the greater interest rate risk on longer bonds. Convexity lowers long yields rather than raising them, and pure expectations would predict a flat curve.

  1. AInvestors demand a positive term premium for bearing duration risk on longer maturitiesCorrect
  2. BConvexity effects cause long-term yields to exceed short yields by a large margin
  3. CForward rates equal expected future spot rates, so slope must reflect error
  4. DShort-term rates are certain to rise in the future

Explanation

With flat expected rates, a positive slope must come from the risk premium (term premium) since long bonds have more price risk. Convexity pulls long yields down, not up. The pure expectations hypothesis would imply a flat curve, and rates are not stated to rise.

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