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

Under the pure expectations hypothesis, which statement about the shape of the term structure is correct?

Under the pure expectations hypothesis, an upward-sloping curve means the market expects short-term rates to rise, because forward rates equal expected future spot rates and no term premium exists. Any slope is therefore entirely explained by rate expectations.

  1. AAn upward-sloping spot curve implies that investors expect short-term rates to riseCorrect
  2. BLong-maturity bonds must offer a constant liquidity premium over short-maturity bonds
  3. CAn upward-sloping curve arises only when investors expect inflation to fall
  4. DForward rates are always above expected future spot rates because of risk aversion

Explanation

The pure expectations hypothesis sets forward rates equal to expected future spot rates with no risk premium. A rising spot curve therefore means forwards, and thus expected future short rates, are above current short rates. The other options introduce premia or unrelated claims.

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