Question

After checking that interest rate yield curves in the financial press are normal than inverted, the treasurer is now looking to hedge the interest rate exposure. Traditionally Sigma Company has used forward rate agreements (FRAs) for hedging interest rate risk exposure but the treasurer is now considering using interest rate futures, although he is concerned that futures will not be as good a hedge as the FRAs.

Sigma Company’s bank have offered an FRA on the following terms:

3v9 FRA 7.2 – 7.8%.

Which one of the following would NOT be a possible explanation for the normal yield curve observed?

Select one:

a. Expectations theory

b. Liquidity preference theory

c. Market segmentation theory

d. An expected rise in interest rates

Answer 1

a) Expectations Theory

The expectation theory states that the shape of the yield curve depends on the market expectations. So, the normal yield curve observed may be due to the expectation to get higher return for long term investment. Inverted yield curve in the initial stage indicates that the long term investors were under the perception that the interest rates will fall in the future. Hence the expectations theory is an explanation for the normal yield curve observed.

b) Liquidity Preference Theory

Liquidity preference theory states that the investors should opt for higher interest rates for long term securities because it involves greater risk. The investors prefer mainly cash or other liquid assets. It is an extension of expectations theory. Hence, liquidity preference theory is an explanation for the normal yeild curve observed.

c) Market Segmentation Theory

This theory states that different securities with different maturities cannot be compared. Securities with longer term will have higher yield and securities with shorter term will have lower yield. Hence, market segmentation theory explains the normal yield curve observed.

d) Expected rise in interest rates

An upward sloping yield curve suggests that there is an expected rise in interest rates. Here, a normal yield curve is observed. It suggests that there will be higher yield for long term investment, because long term investments will have higher risk involved in it. Hence, expected rise in interest rate is not a possible explanation for the normal yield curve observed.

Therefore, it can be concluded that option D is the correct option.