Question

You are having a conversation with your friend Yvonne about the upward-sloping yield curve that currently exists in the bond market. She explains this to you by saying that the upward slope to the yield curve is because the market expects future interest rates to be higher than current interest rates. Her observation means that she is a proponent of the __________ theory of interest rates.

• A. default premium
• B. term premium
• C. segmented market
• D. pure expectations

Answer 1

Option D - Pure Expectation theory.

The term structure in the bond market is based on many different factors such as duration, interest rates, supply and demand and also risk and liquidity. There are some methods to forecast the yield curve which includes market segmentation theory, liquidity premium theory, pure expectations theory, and preferred habitat theory.

The market values yield for different maturity with different premium as the yield for short term instruments tend to be volatile.
So there are different yield expectations for short, medium and long term maturities and this method is known as market segmentation theory.

In the liquidity premium theory, the market sometimes adds a premium to illiquid assets or sometimes discounts the asset.
If there are less number of buyers in that segment then obviously the price will be lower to attract the buyers. There will be a higher transaction cost for illiquid assets to sell and that is a risk which needs to be compensated with a premium.
This theory is known as liquidity premium theory.

Pure expectation theory assumes the yield of bonds tend to move together and so it considers the short term yield as a continuation of one-period bond yield. According to this theory, if the yield curve is upward sloping then the future interest rates are expected to rise. This indicates that the long term bond yield will be higher as compared to the short term bonds.