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FRM Part I · FRM Exam Part I · Properties of Interest Rates

Under the pure expectations theory of the term structure, which of the following best explains an upward-sloping yield curve?

Under the pure expectations theory, long-term rates equal the average of expected future short-term rates, so an upward-sloping curve means the market expects short rates to rise. Liquidity premiums and maturity restrictions come from other theories, not from pure expectations.

  1. AInvestors require a liquidity premium that rises with maturity
  2. BInvestors expect short-term interest rates to rise in the futureCorrect
  3. CInvestors are restricted to bonds matching their liabilities' maturities
  4. DLong-term bonds are always less risky than short-term bonds

Explanation

Pure expectations theory says long rates are averages of expected future short rates, so an upward slope implies expected increases in short rates. The liquidity premium option belongs to liquidity preference theory, and the maturity-restriction option belongs to market segmentation theory.

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