Question

You are having a conversation with your friend Yvonne about the upward-sloping yield curve that currently exists in the bond market. ​She explains this to you by saying that the upward slope to the yield curve is because the market expects future interest rates to be higher than current interest rates. Her observation means that she is a proponent of the __________ theory of interest rates.

(A) default premium
(B) term premium
(C) segmented market
(D) pure expectations

Answer 1

Answer: Pure expectations

                     

Explanation: This theory suggest that the current forward rates depicts the interest rates that are going to be in the future. Using such a theory the investor makes investment based only on the expectations of future interest rates. This is generally seen in the bond market.

In the given case, Yvonne told that the reason behind the upward slope is due to the expectations of the investors that interest rates will increase in the future.

Thus, we can conclude that her observation depicts evidence of pure expectation theory.