Question

Which of the following statements about the term structure of interest rates is incorrect?

• A.

  According to the Liquidity Preference Theory, long-term interest rates are usually higher than short-term interest rates.

• B.

  The Market Segmentation Theory posits that bonds of different maturities are traded by different investors and their prices/yields are determined separately.

• C.

  The Pure Expectations Theory asserts that the yield curve is explained solely by investors' interest rate expectations.

• D.

  According to the Pure Expectations Theory, an upward sloping curve should be typical (theoretically).

• E.

  None of the above statements are incorrect. (All of the above statements are correct.)

Answer 1

D is incorrect. According to the Pure Expectations Theory, an upward sloping curve occurs if future interest rates are expected to rise. However, if future interest rates are expected to decline, then this result in an inverted yield curve.

A is correct. According to the Liquidity Preference Theory, bonds with longer time to maturity carry higher risk, and therefore must have higher yields.

B is correct. According to the Market Segmentation Theory, bonds with different maturities are traded by different investors and their prices/yields are determined separately.

C is correct. The Pure Expectations Theory asserts that the yield curve is explained solely by investors' interest rate expectations.