Pure Expectations Theory in Finance

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Questions and Answers

What is the primary assumption of the Pure Expectations Theory regarding the yield curve?

It reflects market risk premiums for different maturities

It reflects the inflation expectations for the economy

It reflects market expectations of future short-term interest rates (correct)

It reflects the liquidity premiums for long-term bonds

According to the Pure Expectations Theory, what determines long-term interest rates?

Government's monetary policy decisions

Market's expectation of future short-term interest rates (correct)

The total return of short-term bonds

The current level of inflation

What is the typical implication of an upward-sloping yield curve?

Investors expect stronger economic growth and potentially higher inflation in the future (correct)

Investors expect slower economic growth in the future

Investors are indifferent between holding short-term or long-term securities

Investors prefer short-term bonds to lock in current yields

Why do investors demand higher yields for long-term bonds in an upward-sloping yield curve?

To compensate for expected higher inflation and interest rate risks in the future Signup and view all the answers

What is the typical shape of the yield curve when investors expect interest rates to decrease in the future?

Downward-sloping Signup and view all the answers

Why do investors prefer long-term bonds in an inverted yield curve?

To lock in current higher yields Signup and view all the answers

What is the key difference between an upward-sloping and an inverted yield curve?

The direction of expected interest rate changes Signup and view all the answers

What is a rare occurrence in the economy?

Flat yield curve Signup and view all the answers

What is the primary use of forward rates in bond markets?

To hedge against interest rate risk Signup and view all the answers

What happens to bond prices when interest rates increase?

They decrease in value Signup and view all the answers

What is the primary driver of the shape of the yield curve?

Participants' expectations of future interest rate movements Signup and view all the answers

According to the Liquidity Preference Theory, what is the reward for investors who take on more risk?

Extra compensation for taking on more risk Signup and view all the answers

What is the result of a negative forward rate in the bond market?

An arbitrage opportunity Signup and view all the answers

What is the primary characteristic of the Market Segmentation Theory?

Supply and demand shift the yield for each market segment Signup and view all the answers

What is the primary characteristic of the Preferred Habitat Theory?

Investors have preferred time maturity to bonds Signup and view all the answers

Study Notes

Pure Expectations Theory

The theory assumes that the current yield curve solely reflects investors' expectations of future short-term interest rates.
It predicts future short-term rates (forward rates) based on current long-term rates.
The yield curve shape is determined by the market's expectation of future short-term interest rates.
If the market anticipates short-term rates will increase (decrease) in the future, the yield curve will slope upwards (downwards).

Yield Curve Shape

Normal (Upward Sloping)
- Short-term yields are lower than long-term yields.
- Long-term bonds have higher yields compared to short-term bonds.
- Indicates that investors expect stronger economic growth and potentially higher inflation in the future.
- Higher returns for longer maturity bonds due to higher exposure to uncertainty of rate changes and inflation risk.
Inverted (Downward Sloping)
- Short-term bonds have higher yields compared to long-term bonds.
- Indicates that investors expect slower economic growth or a recession in the future.
- Investors prefer long-term bonds to lock in current yields, anticipating that interest rates will fall due to economic weakness.
- Lower returns for having less exposure to uncertainty of rate changes and inflation risk.
Flat Yield Curve
- Rarely observed, only during economic changes, transitioning from upward to downward sloping or vice versa.

Discount Factors/Spot Rates/Forward Rates

Discount Factor: determined from the market price and cashflows of a bond, used to obtain the corresponding spot rate and create a yield curve.
Forward Rates: market expectations of interest rates in the future.
Forward rates vs spot rates indicate what the market thinks will happen in the future.
Bond Risk: short-term bonds have less interest rate risk, while long-term bonds are more sensitive to risk.

Arbitrage Opportunity - Negative Rates

A negative forward rate implies mispricing.
Buy under-priced bonds and sell over-priced bonds to take advantage of the arbitrage opportunity.

Interest Rates

High Interest Rates: decrease in bond prices, providing an opportunity for investors.
Low Interest Rates: increase in bond price, making them more valuable.

Other Theories

Liquidity Preference Theory: investors are compensated for time, but get extra if they invest for longer, taking more risk.
Market Segmentation Theory: investors will never change their preference, and supply and demand shift the yield for each market segment.
Preferred Habitat Theory: investors have preferred time maturity to bonds, but may take other opportunities, considering investment duration, price risk, or tolerance.

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Description

Learn about the Pure Expectations Theory, which assumes that the current yield curve reflects investors' expectations of future short-term interest rates. Understand how it predicts future short-term rates and how it determines long-term interest rates.