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.**

a. State the Pure (Unbiased) Expectations Theory.
b. How is the liquidity preference theory supposed to address
the shortcomings of the pure expectations theory? (Hint: Time to
maturity and liquidity premium)
c. Briefly discuss how the liquidity preference theory explains
the shape of the yield curve. (HInt: Time to maturity and liquidity
premium)

Why is it unlikely that the expectations theory alone is the
correct theory for explaining the yield curve?

According to the pure expectations theory, and given the current
Treasury yields shown in the table below, the expected yield on a 2
year Treasury security one year from today would
be:
Maturity (years)
Treasury Yield
1
2%
2
3%
3
5%

Using the pure expectations theory of the term structure and the
associated equation for the 10 yr GS, explain what forward guidance
means and how the use of it is supposed to influence the
economy.

If the pure expectations theory of the term structure is
correct, which of the following statements is CORRECT?
A. An upward sloping yield curve would imply that interest rates
are expected to be lower in the future.
B. If a 1-year Treasury bill has a yield to maturity of 7% and a
2-year Treasury bill has a yield to maturity of 8%, this would
imply the market believes that 1-year rates will be 7.5% one year
from now.
C. The...

Describe the “pure expectations theory” of the term structure of
interest rates

Assume that inflation is expected to decline steadily in the
future, but that the real risk rate will remain constant. which of
the following statements is correct.
1. if inflation is expected to decline, there can be no maturity
risk premium
2. the expectations theory cannot hold if inflation is
decreasing
3. if the pure expectations theory holds, the corporate yield
curve must be downward sloping
4. if the pure expectations theory holds, the treasury yield
curve must be downward...

A. What is the basic difference between the Expectations
Hypothesis and Liquidity Premium Theory? Which has a higher
interest rate in a normal market?
B. If we have an “inverted yield curve”, what does the
Expectations Hypothesis claim about long and short-term rates?
C. If you see a steep upward slope of the yield curve, are short
term rates expected to rise or fall?

If a higher inflation is expected, what would you expect to
happen to the shape of the yield curve as per the pure expectation
theory? Why? Draw the diagram and explain.

PURE EXPECTATIONS THEORY The yield on 1-year Treasury securities
is 6%, 2-year securities yield 6 2%, 3-year securities yield 6 3%,
and 4-year securities yield 6 5%. There is no maturity risk
premium. Using expectations theory and geometric averages, forecast
the yields on the following securities: a. A 1-year security, 1
year from now b. A 1-year security, 2 years from now c. A 2-year
security, 1 year from now d. A 3-year security, 1 year from now

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