If forward rates are an accurate prediction of spot rates in the future,

If forward rates are an accurate prediction of spot rates in the future, then which of the following is true over a one-year holding period? A) Total return of a 5.5% par 5-year bond will exceed the total return of a 5% par 2-year bond B) Total return of a 5% par 5-year bond will be less than the total return of a 6% 1-year bond C) Total return of a 8% discount 10-year bond will equal the total return of a 4% 2-year premium bond

B) Total return of a 5% par 5-year bond will be less than the total return of a 6% 1-year bond – since they talk of a 1 year holding period…

I don’t get it… Does this have to do with the “averages” example in Schweser, meaning a 2-year 7% bond equals a one-year 5% today and a one-year 9% one year from today?

------WARNING: ANSWER AHEAD Choice “c” is correct. According to the local expectations interpretation, the return on bonds of any maturity will be equal when measured over any short-term holding period. Choice “a” is incorrect. This choice contradicts the local expectations interpretation. Choice “b” is incorrect. This choice contradicts the local expectations interpretation. I’m pretty confused about this. I read up on the local expectations theory variation of the pure expectations theory and I can’t figure out how it applies to this problem. How does the return of an 8% discount 10-year bond equal the total return of a 4% 2-year premium bond over a 1-year holding period?

easy question. c f0=s1 , look for a parity relationship, only one that has “equal” is c. classic cfa question, requires no math, but a test a basic understanding of core concepts

Do you mean to say pure expectations theory? I got this wrong too…

No, it is correct, Local expectations theory is a form of the pure expectations theory which suggests that the returns on bonds of different maturities will be the same over a short-term investment horizon. But, it is testing the same logic as pure expectations theory, so its all relative

Fantastic, I think this is missing from Schweser. Reading it now in CFA. Thanks for the heads up.

This is an awful question. Forward rates are not good predictors of future spot rates, and, using local expectations theory or not, the return on these two bonds will not be the same. The detachment from reality here is almost sickening.

Tips is that everything that got to do with pure expectation, everything should be the same (equal) no matter how long that you hold in anytime. Now, question is why forward rate is biased rate? There has been empirical evidence saying that forward rate tends to be upward, but why it is so? I’m trying to explain this using backdward logics, that forward rate is bias because it’s based on the prediction of the investor on the macro economics in the future. However, different investors (economists) have different views on the future outlook, they estimate different forward rates and even take different sides (one buy another sell). But why, as a sum, it is upward bias? Can anyone here shed a light on this? Thanks.

Wyantjs, you haven’t realized the whole curriculum is fantasy land, look at level I, Modigliani and Miller…yeah let’s pretend that there are no taxes, no costs, etc…I wish.

Don’t understand this at all myself…

trek7000 Wrote: ------------------------------------------------------- > Wyantjs, you haven’t realized the whole curriculum > is fantasy land, look at level I, Modigliani and > Miller…yeah let’s pretend that there are no > taxes, no costs, etc…I wish. Unfortunately I have realized this. What is even worse that the bogus theoretical arguments and models in the cirriculum are presented as if they are truth. It really bothers me sometimes when I read threads on this board and find the high levels of naivete of the candidates, including levels 2 and 3, who think all financial variables are normally distributed, local expectations theory might actually hold, correlations are constant, black-scholes is an equation (not a model), etc…I guess there has to be a limit to the amount and depth of information tested, but I wish they would do so in a manner that doesn’t send people out into the real world with a false sense of knowledge.

wyantjs Wrote: ------------------------------------------------------- > trek7000 Wrote: > -------------------------------------------------- > ----- > > Wyantjs, you haven’t realized the whole > curriculum > > is fantasy land, look at level I, Modigliani > and > > Miller…yeah let’s pretend that there are no > > taxes, no costs, etc…I wish. > > > Unfortunately I have realized this. What is even > worse that the bogus theoretical arguments and > models in the cirriculum are presented as if they > are truth. It really bothers me sometimes when I > read threads on this board and find the high > levels of naivete of the candidates, including > levels 2 and 3, who think all financial variables > are normally distributed, local expectations > theory might actually hold, correlations are > constant, black-scholes is an equation (not a > model), etc…I guess there has to be a limit to > the amount and depth of information tested, but I > wish they would do so in a manner that doesn’t > send people out into the real world with a false > sense of knowledge. I think everyone should read Black Swan, IMO