Question

Explain what the pure expectations theory implies and why the theory is expected to impact the yield curve.

Answer 1

Answer-

Pure expetations theory or Unbiased expectations theory implies that the forward rates are solely a function of expected future spot rates and every maturity strategy has the same expected return over a given investment horizon. The long term interest rates is equal to the mean of expected short term rates.

The prominent prrinciple behind the pure expetations theory is risk neutrality. Investors do not expect risk premium for maturity strategies that differ from their investment horizon.

The various effects on shape of the yield curve under the pure expectations theory are

1) If the yield curve is upward sloping short term rates are expected to rise.
2) If the curve is downward sloping short term rates ar expected to fall.
3) Flat yield curve immplies that the market expects short term rates to remain constant.