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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 par yield curve and wants to explain it using the three standard components of forward rates in the Tuckman-style framework. Which set of components correctly describes what drives the shape of the spot or forward rate curve?

The shape of the term structure is driven by expectations of future short rates, a risk premium demanded for interest rate risk, and a convexity effect. Convexity lowers long-term rates relative to expectations, while the risk premium typically raises them, together shaping the curve.

  1. AExpectations of future short rates, risk premium, and convexityCorrect
  2. BExpected inflation, credit spread, and liquidity premium only
  3. CExpected default losses, bid-ask spread, and coupon effect
  4. DDuration, key rate exposure, and reinvestment risk

Explanation

The term structure shape is explained by expectations of future short-term rates, a risk premium for bearing interest rate risk, and a convexity effect from the nonlinear price-yield relationship. The other sets name items that are not the standard decomposition used in this reading.

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