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The term structure theory that rests on the interaction of supply and demand forces in the debt market is the:

A)
expectation hypothesis.

B)
GIC inverse term structure theory.

C)
market segmentation theory.

The market segmentation theory holds that the market is segmented into different parts based on the maturity preferences of investors. The theory also holds that the supply and demand forces at work within each segment determine the prevailing level of interest rates for that part of the market.

Which of the following statements regarding the different theories of the term structure of interest rates is least accurate?

A)	The market segmentation theory, pure expectations theory, preferred habitat theory, and liquidity preference theory are all consistent with any shape of the yield curve.

B)	The preferred habitat theory suggests that investors prefer to stay within a particular maturity range of the yield curve regardless of yields in other maturity ranges.

C)	An upward sloping yield curve can be consistent with the liquidity preference theory even with expectations of declining short term interest rates.

The preferred habitat theory states that investors prefer to stay within a particular maturity range but will move from their preferred range to another area on the curve to achieve higher yields. With the liquidity preference theory the yield curve can remain upward sloping even if short term rates are predicted to decline as long as the liquidity premium is sufficiently large.

Which of the following is a correct interpretation of forward rates under the pure expectations hypothesis? Forward rates are equal to the expected future:

A)	rate differences between short and long-term bonds.

B)	risk premiums on short-term bills.

C)	spot rates.

An analyst forecasts that spot interest rates will increase more than the increase implied by the current forward interest rates. Under these circumstances:

A)	the analyst should establish a bullish bond portfolio.

B)	all bond positions earn the same return.

C)	the analyst should establish a bearish bond portfolio.

Bond prices fall with a rise in interest rates. If realized rates rise more than the associated forward rate implied, then a bearish bond position will be the most beneficial.

A)	because they are so marketable, there is a liquidity premium that normally has to be paid to invest in short-term debt securities.

B)	the yield curve should be upward-sloping.

C)	cash should be preferred to Treasury securities because it is more liquid.

The liquidity preference theory definitely has an upward-sloping bias with regard to the shape of the yield curve. That is because it holds that investors generally prefer the greater liquidity and reduced risk that accompanies short-term securities and, as a result, require a premium (higher yields) to get them to invest in longer-term securities.

According to the expectations hypothesis, investors’ expectations of decreasing inflation will result in:

A)	a flat yield curve.

B)	a downward-sloping yield curve.

C)	an upward-sloping yield curve.

The expectations hypothesis holds that the shape of the yield curve reflects investor expectations about the future behavior of inflation and market interest rates. Thus, if investors believe inflation will be slowing down in the future, they will require lower long-term rates today and, therefore, the yield curve will be downward-sloping.

Suppose that the one-year forward rate starting one year from now is 6%. Which of the following statements is most accurate under the pure expectations hypothesis? The expected:

A)	future risk premium for short-term bills is 6%.

B)	future one-year spot rate in one year's time is equal to 6%.

C)	one-year forward rate in one year's time is equal to 6%.

According to the pure expectations theory an upward-sloping yield curve implies:

A)	longer-term bonds are riskier than short-term bonds.

B)	interest rates are expected to increase in the future.

C)	interest rates are expected to decline in the future.

According to the expectations hypothesis, the shape of the yield curve results from the interest rate expectations of market participants. More specifically, it holds that any long-term interest rate simply represents the geometric mean of current and future 1-year interest rates expected to prevail over the maturity of the issue. The expectations theory can explain any shape of yield curve.

Expectations for rising short-term rates in the future cause a rising (upward-sloping) yield curve; expectations for falling short-term rates in the future will cause long-term rates to lie below current short-term rates, and the yield curve will decline (or slope downward).

Thus, an upward-sloping yield curve implies that interest rates are expected to increase in the future.

Which theory of the term structure of interest rates concludes that the shape of the yield curve is determined by the supply and demand for securities in particular maturity ranges, and what shape of the yield curve is implied by this theory?

market segmentation

upward sloping

liquidity preference

upward sloping

market segmentation

no specific shape

The shape of the yield curve under market segmentation is determined by the supply and demand for securities within a given maturity range. No specific shape of the yield curve is implied by this theory.

A)	the supply of long-term funds falls short of demand.

B)	the supply of long-term funds falls short of demand and investors begin to show a preference for more liquid/less risky short-term securities.

C)	inflationary expectations are beginning to subside and investors begin to show a preference for more liquid/less risky short-term securities.

When demand for loanable funds outstrips supply, interest rates can be expected to rise in that (long-term) segment of the market; also, more preference for short-term securities can be expected to drive up long-term rates as the liquidity premium rises. Thus, both circumstances in the answer can be expected to put upward pressure on the long end of the yield curve.

A)	the supply of long-term funds falls short of demand.

B)	the supply of long-term funds falls short of demand and investors begin to show a preference for more liquid/less risky short-term securities.

C)	inflationary expectations are beginning to subside and investors begin to show a preference for more liquid/less risky short-term securities.

If the slope of the yield curve begins to rise sharply, it is usually an indication that:

A)	stocks are offering abnormally high rates of return.

B)	the Fed has been aggressively driving up short-term interest rates.

C)	the rate of inflation is starting to increase or is expected to do so in the near future.

According to the expectations hypothesis, higher long-term interest rates and, therefore, upward-sloping yield curves will occur if the rate of inflation starts to heat up or is expected to do so in the near future.