1 Which of the following is NOT an assumption behind the Pure Expectations Theor

Question

1 Which of the following is NOT an assumption behind the Pure Expectations Theory? Investors will switch between short- and long-term investments in order to achieve the highest return. (a) (b) Investors have a preference for long-term securities. (c) There are no transaction costs (d) There are no taxes. 2 Which of the following is a plausible reason why an upward sloping yield curve is considered "normal", in that it is most commonly observed? (a) Investors have a preference for short-term securities, resulting in an upward bias compared to the (b) Investors are generally optimistic, and predict increasing interest rates in the future more often than (c) You earn more interest from investing for a long period of time than by investing for a short period of (d) Investors have a preference for long-term securities, resulting in an upward bias compared to the 3 Which of the following theories predicts that the yield for each maturity will be a function of Pure Expectations yield curve. they predict decreasing interest rates time, so it is natural that the long-term yield will always be greater than the short-term yield Pure Expectations yield curve. demand and supply for maturities of that maturity? (a) The Pure Expectations theory (b) The Liquidity Premium theory (c) The Market Segmentation theory (d) All theories make this prediction 4 If the current one-year yield is 2.9% and the current two-year yield is 3.3%, what is the implied year rate one year from now? o (a) 3.30% (b) 3.96% (c) 3.70% (d) 3.33%

Explanation / Answer

(1) The pure expecttations theory is entirely based on the premise that long-term interest rates are a combination of continuous rolled over short-term rates. This essentially implies that an amount of money invested at the long-term rate of say R for say T years would yield a maturity value equal to an amount invested for 1 year at the short-term rates and the investment proceeds (1 year later) being rolled over into another year-long short-term investment at the short-term rate prevailing 1 year later and so on for T years. Hence, short-term rates set expectations for long-term rates. Mathematically the same can be depicted as:

K x (1+R)^(T) = K x (1+r1) x (1+r2) x .................x(1+rt) where r1,r2,r3,......rt are short-term annual rates (where 1+2+3+4+.......+t = T) and R is the T-year long interest rate.

This equation will hold only when the investments for long-term/short-term are NOT subjected to transaction costs (while rolling over one investment into another) and/or taxes. Further, as investors can earn the same amount through both long-term or multiple short-term investments, they should be neutral between the two, thereby switching between the two to ensure the highest possible return. However, the neutral view towards both long-term and short-term investments imply that they do NOT consider long-term investments to be risky. Hence, the same is not an assumption under the Pure Expectations Theory.

Therefore, the correct option is (b).

NOTE: Please raise separate queries for solutions to the remaining unrelated questions. The remaining questions are related to the same topic yet separate from the first one, therefore the request for separate queries.

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