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

A trader observes that the forward rate for a future period is 4.50%, while the expected future spot rate for that period is 4.10%. Ignoring convexity, which interpretation is best supported?

The forward rate exceeds the expected future spot rate by 0.40%, which indicates a positive term premium of about 0.40% embedded in the forward rate. Under pure expectations they would be equal, and convexity is excluded by assumption.

  1. AThe market embeds a positive term premium of about 0.40% in the forward rateCorrect
  2. BThe market embeds a negative term premium of about 0.40% in the forward rate
  3. CThe pure expectations hypothesis holds, so no premium exists
  4. DConvexity of 0.40% fully explains the gap, so risk premium must be zero

Explanation

Forward minus expected spot is the term premium: 4.50% - 4.10% = 0.40%, positive. A negative premium reverses the sign. Pure expectations would require equality. The question says to ignore convexity, so it cannot explain the gap.

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