- CFA Exams
- CFA Level I Exam
- Study Session 12. Fixed Income (1)
- Reading 32. The Term Structure and Interest Rate Dynamics
- Subject 5. Traditional Theories of the Term Structure of Interest Rates
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
|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!|