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ACCA Applied Skills · Financial Management · Causes of exchange rate differences and interest rate fluctuations

The yield curve for government bonds currently slopes downwards, with short-term yields above long-term yields. Which theory explains this by market expectations alone?

Expectations theory explains an inverted curve: long-term yields reflect the average of expected future short-term rates, so a downward slope means the market expects short-term interest rates to fall. Liquidity preference would push long yields higher, not lower.

  1. ALiquidity preference theory
  2. BExpectations theory, with markets expecting short-term rates to fall in futureCorrect
  3. CMarket segmentation theory, with long-term supply exceeding demand
  4. DPurchasing power parity theory

Explanation

Pure expectations theory says long-term rates are an average of expected future short-term rates. A downward slope implies expected falls in short rates. Liquidity preference would produce an upward bias, not a downward slope, and purchasing power parity concerns exchange rates.

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