In: Finance
Based on the pure expectations theory, if the implied forward rates under the no-arbitrage condition are lower than spot rates of matching maturities, then the spot rate curve is most likely Group of answer choices
flat
downward sloping
upward-sloping
The spot rate curve is most likely downward sloping.
For example, let us take the case of a simple 2-year scenario.
As per expectations theory, investing for 2 years at the 2-year rate should result in the same ending value as investing for 1 year at the 1-year rate, and reinvesting the proceeds after 1 year at the 1-year rate 1 year from now.
If the implied forward rate (1-year rate 1 year from now) is lower than the spot rate, it means that the spot rate curve is downward sloping (the 2-year spot rate is lower than the 1-year spot rate).