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

In a one-factor model, a bond's duration is 8 and the market price of interest rate risk is 0.25 per unit of volatility. Annual rate volatility is 1.20%. Ignoring convexity, what is the approximate annual expected excess return of the bond over the short rate?

The expected excess return equals duration times the market price of risk times rate volatility: 8 times 0.25 times 1.20% equals 2.40% per year. It compensates the investor for exposure to the single rate factor, scaled by how sensitive the bond is to rate changes.

  1. A2.40%Correct
  2. B0.30%
  3. C9.60%
  4. D0.15%

Explanation

Excess return ≈ duration × λ × σ = 8 × 0.25 × 1.20% = 2.40%. Using 0.25×1.20% alone gives 0.30%, omitting duration. Multiplying 8 × 1.20% gives 9.60%, omitting the price of risk.

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