Question #76
Reading: Reading 25 The Term Structure and Interest Rate Dynamics
PDF File: Reading 25 The Term Structure and Interest Rate Dynamics.pdf
Page: 30
Status: Unattempted
Correct Answer: B
Question
According to the liquidity theory, how are forward rates interpreted? Forward rates are:
Answer Choices:
A. expected future spot rates
B. expected future spot rate plus a rate exposure premium
C. equal to futures rates
Explanation
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.