Which one of the following statements about the term structure of interest rates is true? A. The expectations hypothesis indicates a flat yield curve if anticipated future short-term rates exceed current short-term rates. B. The expectations hypothesis contends that the long-term rate is equal to the anticipated short-term rate. C. The liquidity premium theory indicates that, all else being equal, longer maturities will have lower yields. D. The market segmentation theory contends that borrowers and lenders prefer particular segments of the yield curve.
D or A?
Answer should be D. A should not be correct as the flat yield anticpiate future short term rate will be equal to current rates.
D. Market segmentation theory states how the investors are grouped and concentrate on specific areas of yield curve. Liquidity premium indicates maturities with low liquidity demand higher yields. so, long term maturities have higher yields than short term maturities. Pure Expectations theory takes into account inflation, and with rising inflation expects higher rates for long term maturities.
Correct answer is D. Good job guys.
Could someone please explain why B is incorrrect? Thanks.
To be correct B should be worded as "The expectations hypothesis contends that the long-term rate is spot rate expected in future. " EH believes forward rates computed using current spot rates are best guess of future interest rates. I hope that clears.
Thank you, krishh.