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FRM Part I · FRM Exam Part I · Properties of Interest Rates

An analyst observes an upward-sloping yield curve. Which statement is consistent with the liquidity preference theory but not with the pure expectations theory?

Liquidity preference theory allows an upward-sloping curve even when short rates are expected to remain unchanged, since forward rates contain a positive term premium compensating investors for the greater risk of longer maturities. Pure expectations theory would imply a flat curve in that case.

  1. AForward rates equal expected future spot rates, so a rising curve means rates are expected to rise.
  2. BAn upward-sloping curve can occur even if future short rates are expected to stay unchanged, because forward rates include a positive term premium.Correct
  3. CInvestors are unwilling to move away from their preferred maturity, so each maturity's yield is set independently.
  4. DLong-term rates must always be below short-term rates because of reinvestment risk.

Explanation

Liquidity preference says investors demand a premium for holding longer bonds, so forward rates exceed expected future spot rates. Hence the curve can slope upward with flat expectations. Option A is pure expectations, and option C is market segmentation.

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