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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 reviews a model in which the one-period expected return on a long-maturity zero-coupon bond exceeds the short-term riskless rate. In the term structure framework used for the FRM reading, what does this excess expected return represent?

The excess expected return on a long-maturity bond over the short rate is a risk premium, the compensation investors require for bearing interest rate risk. It is an expected, not certain, return, so it is not arbitrage or a pure convexity gain.

  1. ACompensation for bearing interest rate risk, i.e., a risk premiumCorrect
  2. BThe convexity gain that arises with certainty from a rate change
  3. CA pure arbitrage profit that disappears when the bond is hedged
  4. DThe expected change in the short rate under the risk-neutral measure

Explanation

The expected return of a longer-maturity bond over the riskless short rate is the premium investors demand for bearing exposure to rate moves. It is not a riskless arbitrage, because it is earned only in expectation. Convexity is a separate effect on the yield curve shape, not this compensation.

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