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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 says the observed forward curve is a biased predictor of future short rates because of a term premium. Which empirical observation best supports this view?

Forward rates that on average exceed later realized spot rates support a positive term premium. The excess is compensation for bearing interest rate risk, so forwards are biased predictors of future short rates, contradicting the pure expectations hypothesis.

  1. AForward rates have on average exceeded subsequently realized spot ratesCorrect
  2. BForward rates have equaled realized spot rates in every period
  3. CSpot rates have never changed over time
  4. DLong-term rates have always been lower than short-term rates

Explanation

If forwards persistently exceed later realized short rates, the difference reflects compensation for risk, a positive term premium. Exact equality would support the pure expectations hypothesis. The other statements are implausible or irrelevant.

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