Question #26
Reading: Reading 25 The Term Structure and Interest Rate Dynamics
PDF File: Reading 25 The Term Structure and Interest Rate Dynamics.pdf
Page: 10
Status: Correct
Correct Answer: A
Question
The liquidity theory of the term structure of interest rates is a variation of the pure expectations theory that explains why:
Answer Choices:
A. the yield curve usually slopes downward
B. duration is an imprecise measure
C. the yield curve usually slopes upward
Explanation
The pure expectations hypothesis says that the shape of the yield curve only reflects
expectations of future short-term rates. Yet, the yield curve generally slopes upward. The
liquidity theory says that the yield curve incorporates expectations of short-term rates;
however, the tendency for the yield curve to slope upward reflects the demand for a
higher return to compensate investors for the extra interest rate risk associated with
bonds with longer maturities.