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ACCA Applied Skills · Financial Management · The nature and role of financial markets and institutions

Which of the following is most likely to be indicated by a downward-sloping (inverted) yield curve under the pure expectations theory?

An inverted yield curve under pure expectations theory indicates that investors expect short-term interest rates to fall in future. Long-term yields reflect the average of expected future short-term rates, so if they are lower than current short-term yields, rates must be expected to decline.

  1. AInvestors expect short-term interest rates to fall in futureCorrect
  2. BInvestors expect short-term interest rates to rise in future
  3. CInvestors require a large liquidity premium on long-dated bonds
  4. DShort-dated bonds are in lower demand than long-dated bonds because of default risk

Explanation

Under pure expectations theory, long-term yields are an average of expected future short-term rates. If long-term yields are below short-term yields, the market must expect short-term rates to fall. A rise in expected rates would give an upward-sloping curve, and a large liquidity premium would also steepen it upward.

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