Which of the following is an assumption of the pure expectations hypothesis? The maturity risk premium is zero . Which of the following is true for a bond whose required return is greater than its coupon rate?
What are the assumptions of pure expectation theory?
The simplest of the interest rate theories is the pure expectations theory which assumes that the term structure of an interest contract only depends on the shorter term segments for determining the pricing and interest rate of longer maturities .
What is the expectation hypothesis What is missing from the expectation hypothesis?
The expectation hypothesis neglects the risks inherent in investing in bonds (because forward rates are not perfect predictors of future rates). ... Interest rate risk.
What is the formula of pure expectations theory?
#1 – Pure Expectations Theory
The assumption of this theory is that forward rates . Forward rate = [(1 + S1)n1 / (1 + S2)n2]1/(n1-n2) – 1read more represent the upcoming future rates. In a way, the term structure represents the market expectation on short-term interest rates.
What is expectation theory?
Expectations theory attempts to predict what short-term interest rates will be in the future based on current long-term interest rates . The theory suggests that an investor earns the same interest by investing in two consecutive one-year bond investments versus investing in one two-year bond today.
What is expectation theory and liquidity preference theory?
Based expectations theory asserts that factors other than current expectations of future short-term interest rates influence current long-term interest rates. ... Biased expectations theory has two major variants; liquidity preference theory and preferred habitat theory.
What is unbiased expectation theory?
Unbiased Expectations Theory states that current long-term interest rates contain an implicit prediction of future short term interest rates . ... If we assume the theory to be true, we can use it to make practical predictions about the future of bond yields for our own investing.
What is the pure expectations theory What does the pure expectations theory imply about the term structure of interest rates?
A theory that asserts that forward rates exclusively represent the expected future rates . In other words, the entire term structure reflects the market’s expectations of future short-term rates. For example, an increasing slope to the term structure implies increasing short-term interest rates.
How are upward sloping yield curves explained by the pure expectations theory?
According to the expectations hypothesis, if future interest rates are expected to rise , then the yield curve slopes upward, with longer term bonds paying higher yields.
What is preferred habitat theory?
What Is the Preferred Habitat Theory? The preferred habitat theory is a term structure hypothesis suggesting that different bond investors prefer a particular maturity length over another , and they are only willing to buy bonds outside of their maturity preference if risk premia for other maturity ranges are available.
The CORRECT statement is c. If rates fall after its issue, a zero-coupon bond could trade for an amount above its par value. When rates fall, a zero-coupon bond is likely to trade higher i.e. at a premium that would help an investor to earn capital gains too along with interest income.
Liquidity Preference Theory is a model that suggests that an investor should demand a higher interest rate or premium on securities with long-term maturities that carry greater risk because, all other factors being equal, investors prefer cash or other highly liquid holdings.
In economics, a liquidity premium is the explanation for a difference between two types of financial securities (e.g. stocks) , that have all the same qualities except liquidity. It is a segment of a three-part theory that works to explain the behavior of yield curves for interest rates.
What is the expectation theory of the term structure?
The expectations theory of the term structure holds that the long-term interest rate is a weighted average of present and expected future short-term interest rates . If future short rates are expected to remain constant, then the long rate will equal the short rate (plus a constant risk premium).
What is expectation theory in education?
The expectation theory is the belief that students performances are affected by the teachers expectations from each children .
What does expectations mean in economics?
Expectations (in economics) are essentially forecasts of the future values of economic variables which are relevant to current deci- sions . ... Similarly, farmers have to forecast future prices for various crops in order to determine which crops are most profitable to plant.
What is local expectation theory?
Local expectations theory. A form of the pure expectations theory that suggests that the returns on bonds of different maturities will be the same over a short-term investment horizon .
The risk premium is the excess return above the risk-free rate that investors require as compensation for the higher uncertainty associated with risky assets. The five main risks that comprise the risk premium are business risk, financial risk, liquidity risk, exchange-rate risk, and country-specific risk .
Expectation states theory states that people use available information in order to set expectations for what others can do . The two things that people use to set these expectations are: Skills and abilities. Other information (such as race, age, sex, socioeconomic class, and education)
What is regressive expectation model?
According to the regressive expectations model, a bond holder has an expected return on the bond from . two sources , the bond’s yield — the interest payment he receives — and a potential capital gain — an. increase in the price of the bond after he buys it.
What are the three theories explaining the shape of the yield curve?
Three economic theories— the expectations, liquidity-preference, and institutional or hedging pressure theories —explain the shape of the yield curve.
What is the main disadvantage of the rational expectations approach?
The greatest criticism against rational expectations is that it is unrealistic to say and to assert that individual expectations are essentially the same as the predictions of the relevant economic theory .
What effect does a high credit risk have on securities?
Credit risk is the potential loss to investors due to the issuer of a security being unable to repay all or part of its interest or principal due. The greater the credit risk on an investment, the higher the yield investors demand to compensate for it .
What is needed or added to the expectations theory to form a more accurate theory or more complete model?
The expectations theory of the term structure of interest rates is the idea that investors compare bonds with different times to maturity and choose the ones that yield the highest return. ... To form a more accurate theory, a risk premium must be added to the analysis.
What factors affect the level of bond yields at a point in time?
The most influential factors that affect a bond’s price are yield, prevailing interest rates, and the bond’s rating . Essentially, a bond’s yield is the present value of its cash flows, which are equal to the principal amount plus all the remaining coupons.
What does a downward sloping yield curve mean according to the pure expectations hypothesis?
Under the pure expectations theory, a yield curve that is upward (downward) sloping, means that short-term rates are expected to rise (fall) .
What is Keynesian liquidity preference theory?
KEYNES’ LIQUIDITY PREFERENCE THEORY OF INTEREST. Keynes defines the rate of interest as the reward for parting with liquidity for a specified period of time . According to him, the rate of interest is determined by the demand for and supply of money.
How do preferred habitat hypothesis explain the term structure of interest rates?
The preferred habitat theory states that the market for bonds is ‘segmented’ by term structure and that bond. The bond issuer borrows capital from the bondholder and makes fixed payments to them at a fixed (or variable) interest rate for a specified period. market investors have preferences for these segments.
Which of the following bonds has the greatest price risk?
The answer is d. A 10-year, $1,000 face value, zero coupon bond . A zero-coupon bond is sold at a deep discount, which indicates that its bond’s price is significantly sensitive to the change in market interest rates. From that, it represents the greatest price risk compared to other given investments.
What is an upward sloping yield curve?
An upward sloping yield curve suggests that financial markets expect short-term interest rates to rise in the future . ... In addition to the slope of the yield curve, we also are interested in changes or shifts in yield curves over time.
Why is the yield curve upward sloping?
A yield curve is typically upward sloping; as the time to maturity increases, so does the associated interest rate . ... Therefore, investors (debt holders) usually require a higher rate of return (a higher interest rate) for longer-term debt.
The liquidity premium theory’s key assumption is that bonds of different maturities are substitutes , which means that the expected return on one bond does influence the expected return on a bond of a different maturity.
What is a liquidity spread?
The term liquidity spread is used to describe the premium that flows to a party willing to provide liquidity to a party that is demanding it . Liquidity spreads apply to investments such as stocks and bonds, futures contracts, exchange-traded securities, options, commodities as well as other types of assets.
The risk premium is the rate of return on an investment over and above the risk-free or guaranteed rate of return . To calculate risk premium, investors must first calculate the estimated return and the risk-free rate of return.
When the terms premium and discount are used in reference to bonds, they are telling investors that the purchase price of the bond is either above or below its par value . ... Bonds can be sold for more and less than their par values because of changing interest rates.
When a bond is sold at a discount, the stated rate of interest is lower than the effective rate of interest on the bond. In contrast, when a bond is sold at a premium, the stated rate of interest is higher than the effective rate of interest. 12.
So, when interest rates fall, bond prices rise as investors rush to buy older higher-yielding bonds and as a result , those bonds can sell at a premium. Conversely, as interest rates rise, new bonds coming on the market are issued at the new, higher rates pushing those bond yields up. ... So, those bonds sell at a discount.
The liquidity premium would then force a long-term bond to pay a higher yield. According to the liquidity premium theory, this means that the yield curve will be sloping slightly upward even when short-term rates are expected to remain constant .
How does liquidity preference theory explain interest rate determination?
The Liquidity Preference Theory says that the demand for money is not to borrow money but the desire to remain liquid . In other words, the interest rate is the ‘price’ for money. ... He also said that money is the most liquid asset and the more quickly an asset can be converted into cash, the more liquid it is.
What is the pure expectations theory What does the pure expectations theory imply about the term structure of interest rates?
A theory that asserts that forward rates exclusively represent the expected future rates . In other words, the entire term structure reflects the market’s expectations of future short-term rates. For example, an increasing slope to the term structure implies increasing short-term interest rates.
Which fact about the term structure is the expectations theory unable to explain?
Which fact about the term structure is the Expectations Theory unable to explain? ... short-term interest rates are above long-term interest rates.
What does the expectations theory of the term structure of interest rates imply?
The expectations theory of the term structure of interest rates states that the yields on financial assets of different maturities are related primarily by market expectations of future yields . ... This provides scope to test for the impact of policy or institutional changes on the expectations theory.
