Chartered Financial Analyst (CFA) Practice Exam Level 2

According to Pure Expectations Theory, how does the yield curve shape itself?

1. It is determined by past interest rates

2. It depends solely on the maturity of bonds

3. It reflects investors' expectations about future interest rates

4. It is influenced mainly by economic policies

The correct answer is: It reflects investors' expectations about future interest rates

The yield curve, as described by Pure Expectations Theory, reflects investors' expectations about future interest rates. This theory posits that the shape of the yield curve is determined exclusively by what investors believe will happen to future interest rates rather than by historical rates or current yields. If investors expect future interest rates to rise, the yield curve will slope upward, indicating higher yields for longer maturities. Conversely, if investors believe that future interest rates will decline, the yield curve may slope downward or flatten. This theory effectively suggests that the term structure of interest rates is not just a reflection of current economic conditions but rather a forecast of future rates, thereby shaping the yield curve based on collective investor expectations. In contrast, influences like past interest rates, the maturity of bonds alone, and economic policies, while they may play roles in the broader financial landscape, do not directly shape the yield curve according to this theory. The essence of Pure Expectations Theory is the predictive nature of the yield curve based on anticipated future interest rates.