Based on the pure expectations theory, if the implied forward rates under the no-arbitrage condition are...

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

Solutions

Expert Solution

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).

jeff jeffy answered 2 years ago

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