Chartered Financial Analyst (CFA) Practice Exam Level 2

What does the Pure Expectations Theory imply about forward rates?

1. They are biased predictors of future spot rates

2. They are not related to spot rates

3. They are unbiased predictors of future spot rates

4. They depend solely on current market conditions

The correct answer is: They are unbiased predictors of future spot rates

The Pure Expectations Theory posits that the forward rates derived from the yield curve are expected to reflect the market's anticipation of future changes in spot rates. Specifically, this theory suggests that the forward rate is an unbiased predictor of the future spot rate. Under this framework, if investors expect that interest rates will rise, the forward rates will reflect this expected increase. Conversely, if a drop in interest rates is anticipated, the forward rates will trend lower. This theory indicates that forward rates incorporate all available information about future interest rate movements, thus acting as unbiased forecasts of what spot rates will be at a future date. The implication is that if one were to take the average of a series of forward rates over a specific period, it would equal the average of the corresponding future spot rates—meaning that the predictions made by forward rates do not lean in favor of being optimistic or pessimistic. In contrast, the idea of bias in forward rates or their lack of relation to current market conditions is inconsistent with the fundamental tenets of the Pure Expectations Theory, which emphasizes that current market conditions and rates are key inputs in determining future expectations.