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

The current one-year rate is 3.00%. The one-year rate one year forward is 4.00% (annually compounded). A risk manager estimates that the expected one-year rate in one year is 3.60%. What is the implied annualized term premium for the second year, and how should it be interpreted?

The term premium is the forward rate minus the expected future short rate: 4.00% minus 3.60% equals 0.40%. It is positive, meaning the forward rate exceeds expectations and investors are compensated for bearing the interest rate risk of holding the longer-maturity bond.

  1. A0.40%; investors are compensated for bearing interest rate risk on the longer bondCorrect
  2. B0.40%; the curve is inverted
  3. C-0.40%; investors are compensated for bearing interest rate risk
  4. D0.60%; the expected rate exceeds the forward

Explanation

Term premium = forward rate minus expected future spot rate = 4.00% - 3.60% = 0.40%. A positive value means the forward embeds compensation for holding longer-maturity bonds. The sign-reversed option subtracts in the wrong order.

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