CFA Practice Question

There are 147 practice questions for this study session.

CFA Practice Question

Which of the following statements is (are) true with respect to the various theories of the term structure of interest rates?

I. The market segmentation theory asserts that the shape of the yield curve will be determined by the supply and demand for bonds representing a specified range of maturities.

II. According to the pure expectations theory, future estimates of interest rates are certain and therefore the yield curve should be flat.

III. The liquidity theory asserts that everything else is held constant, then the yield curve must be upward sloping.

IV. The preferred habitat theory asserts that in general, investors prefer to hold on to shorter term maturities.
A. I and III
B. III and IV
C. I, II, III, and IV
Explanation: II is incorrect because according to the pure expectations theory, future estimates of interest rates are not certain. However, these expectations will shape the yield curve. For instance, if future interest rates are expected to increase, then the yield curve will be upward sloping.

III is true because the liquidity theory asserts that if everything else is held constant, investors would prefer to hold shorter term securities because they are less risky. Hence, in order to entice investors to hold longer term maturity bonds, they must be offered a "liquidity premium", in effect, a higher yield. Thus, the yield curve must be upward sloping.

IV is incorrect because the preferred habitat theory asserts that investor preference for a particular maturity will primarily be determined by the duration of the investor's liabilities. For instance, if an investor has a long term liability, he or she would actually prefer longer term bonds.

User Contributed Comments 3

User Comment
HenryQ Biased expectation theory and preferred habitat theory suggest any shape of yield curve is possible.
dblueroom The explanation says "future estimates of interest rates are not certain" about the pure expectation theory and just a couple of questions before, quote "forward rates are perfect predictors of future interest rates and returns are certain and independent of the maturity of investment" a bit contradicting?
chamad dblueroom: different theories have contradicting predictions!
You need to log in first to add your comment.