Skip to content

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

A treasury desk finds that, historically, forward rates have systematically exceeded the subsequently realized short rates. Which interpretation is most consistent with this evidence?

The pattern is consistent with a positive term premium. Forward rates equal expected future short rates plus compensation for bearing interest rate risk, so they run above realized rates on average. If the pure expectations hypothesis held, there would be no persistent gap.

  1. AForward rates embed a positive term premium, so they are upward-biased predictors of future short ratesCorrect
  2. BThe pure expectations hypothesis holds exactly, so forwards are unbiased predictors
  3. CForward rates are below expected short rates because of negative convexity
  4. DInvestors are risk-seeking and demand lower yields on long bonds

Explanation

Forwards equal expected future short rates plus a risk premium (and convexity effect). If forwards persistently exceed realized rates, a positive premium compensating for interest rate risk is the natural explanation. Exact expectations hypothesis would imply no persistent gap.

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