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

An analyst observes an upward-sloping forward curve and states that, under the pure expectations hypothesis, this implies investors expect short-term rates to rise. A colleague argues that forward rates also include a term premium. Which statement is correct?

Under the pure expectations hypothesis forward rates equal expected future spot rates, because no risk premium exists. An upward-sloping forward curve therefore signals expected rises in short rates. Term premia or convexity effects only arise when the hypothesis is relaxed.

  1. AUnder pure expectations, forward rates equal expected future spot rates, so upward slope means expected rate risesCorrect
  2. BUnder pure expectations, forward rates exceed expected spot rates by a positive term premium
  3. CUnder pure expectations, the curve slope reflects only convexity
  4. DUnder pure expectations, expected holding returns on long bonds exceed those on short bonds

Explanation

Pure expectations sets the risk premium to zero, so forwards equal expected future short rates and slope reflects expected rate changes. Term premia belong to alternative theories, and expected returns are equal across maturities.

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