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IAI Actuarial Core Principles · Actuarial Mathematics for Modelling · Term structure of interest rates

Under the pure expectations theory of the term structure, the yield curve is upward sloping when investors expect which of the following?

The curve slopes upward when future short-term rates are expected to be higher than current ones. In the pure expectations theory, long-term yields are averages of expected future short rates, so rising expectations produce rising yields with term and a positive slope.

  1. AFuture short-term interest rates to be higher than current short-term ratesCorrect
  2. BFuture short-term interest rates to be lower than current short-term rates
  3. CFuture short-term rates to be unchanged but long bonds to be less liquid
  4. DInflation to fall while the supply of long-dated bonds rises
  5. Investors to prefer short-dated bonds because of lower price volatility

Explanation

Under pure expectations, long yields are an average of expected future short rates. An upward sloping curve therefore signals expected rises in short rates. Unchanged expected rates would give a flat curve, since the pure theory has no liquidity premium.

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