In schweser mocks (book 1, exam 3, #60) the paragraph and question are as follows:
Berg also observes that th current treasury bond yield curve is upward sloping. Based on this observation, Berg forecasts that short term interest rates will increase.
Is Berg’s short term interest rate forecast consisitent with the pure expectations theory and the liquidity theory?
a. consisent with both
b. consistent with pure expectations theory only
c. consistent with liquidity theory only
The answer is B however i dont understand why A is not correct! can someone please clairfy? many thanks!
In the liquidity theory, investors attach a risk premium on top of the interest rate for holding the bond over time. The longer the time horizon, the greater the risk premium is attached. So, interest rates could be flat or falling, but because of the premium that is attached to the interest rates it would cause the curve to slope upward.
If the curve is sloping downward, then interest rates are definitely forecasted to fall. However, if it is sloping upward it could be because
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The interest rates are forecasted to increase OR
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interest rates are flat or falling and the risk premium attached to the interest rates is enough to cause an upward slope.
Hope this helps!
Pure expectations says that today’s one-year forward rate starting one year from now will be next year’s 1-year spot rate.
Liquidity preference says that if you want to hold my money for longer, you have to pay me more. It says nothing about what today’s yield curve implies about tomorrow’s yield curve.