土豆妮

Assuming the pure expectations theory is correct, 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.

---

The yield curve slopes upward because short-term rates are lower than long-term rates. Since market rates are determined by supply and demand, it follows that investors (demand side) expect rates to be higher in the future than in the near-term.

土豆妮

According to the liquidity theory, how are forward rates interpreted? Forward rates are:

A) equal to futures rates.

B) expected future spot rate plus a rate exposure premium.

C) expected future spot rates.

---

The liquidity theory of the term structure proposes that forward rates reflect investors’ expectations of future rates plus a liquidity premium to compensate them for exposure to interest rate risk, and this liquidity premium is positively related to maturity. The implication of the liquidity theory is that forward rates are a biased estimate of the market’s expectation of future rates, since they include a liquidity premium.