Chartered Financial Analyst (CFA) Practice Exam Level 2

What is a notable feature of Local Expectations Theory?

1. It does not account for risk premiums

2. It assumes risk premiums only exist in the long run

3. It preserves risk-neutrality assumptions for short holding periods

4. It emphasizes market speculation over time

The correct answer is: It preserves risk-neutrality assumptions for short holding periods

Local Expectations Theory has a noteworthy feature in its assumption of risk-neutrality for short holding periods. This aspect means that, within a short timeframe, investors are assumed to make decisions based solely on expected returns, without any additional consideration for risk. This theory recognizes that in the short run, the effects of risk premiums can be negligible, allowing investors to operate under a risk-neutral framework, where the expected returns on investment are aligned with risk-free rates. This concept is crucial because it provides a simplified perspective on yield curves and term structure, allowing market participants to understand and predict interest rates and investment returns without the complexities introduced by risk perceptions in short durations. By focusing on short-term expectations, Local Expectations Theory simplifies the analysis and can effectively demonstrate how current market conditions influence future rates and prices, emphasizing a more theoretical approach rather than a practical one. In contrast, other theories or features related to expectations about long-term investments might place more emphasis on risk premiums or speculative behaviors, which are not a central focus of Local Expectations Theory in its immediate context. This clarity in short-term risk neutrality is what distinguishes this theory, allowing it to stand out in the study of financial markets and interest rate behaviors.