Question

If market participants notice that a variable behaves differently now than in the past, then, according to rational expectations theory, we can expect market participants to

Ans: change the way they form expectations about future values of the variable.

The risk structure of interest rates is

Ans: the relationship among interest rates of different bonds with the same maturity.

Could you please give me an explanation to these two questions? I have the answers but I need an explanation to study.

Answer 1

First we need to understand what rational expectation theory proposes. It says that individuals make their decisions based on three major factors: their human rationality, the information available , and their past experiences.

Now, when market participants notice that a variable behaves differently now than in the past, then, according to rational expectations theory, we can expect market participants to change the way they form expectations about future values of the variable.

Example: Fed decreased interest rates to reduce recessionary impact and people believed that interest rates will continue to go down but if they are increased then people may not use past experience they will make decision based on current rationality and may change the way they are investing.

The risk structure of interest rates is the relationship among interest rates of different bonds with the same maturity.

More the risk, more the returns. If a company has risky assets and wants people to invest then it has to offer higher interest rates. If a company is risk free then it offers less interest rates.

Hence, different bonds with same maturity may offer different interest rates.