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IAI Actuarial Core Principles · Economic Modelling · Models of the term structure of interest rates

According to the pure expectations theory of the term structure, what explains an upward-sloping yield curve?

Under the pure expectations theory, an upward-sloping yield curve arises because the market expects future short-term interest rates to rise. Long-term yields are just averages of the expected short rates, with no separate liquidity or maturity-preference premium.

  1. AInvestors demand a liquidity premium for longer maturities
  2. BInvestors are segmented into preferred maturity habitats
  3. CMarkets expect short-term interest rates to rise in the futureCorrect
  4. DLong-dated bonds have lower default risk than short-dated bonds
  5. Central banks fix long-term rates above short-term rates

Explanation

Under pure expectations, long rates are geometric averages of expected future short rates, so a rising curve means rising short rates are expected. Liquidity preference and market segmentation are separate theories that give other explanations.

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