Which of the following DOES NOT correctly describe how the various theories of t

Question

Which of the following DOES NOT correctly describe how the various theories of the term structure of interest rates explain a "flat" yield curve? A.  Segmented markets theory: Investors prefer long-term to short-term bonds. B.  Liquidity premium theory: The liquidity premium on medium- and long-term bonds equals zero and expected future short-term rates are constant. C.  Expectations theory: Interest rates are expected to remain steady in the future. D.  Expectations theory: Interest rates are equally likely to fall or rise in the future. E.  Preferred habitat theory: Interest rates are expected to fall moderately in the future. Which of the following DOES NOT correctly describe how the various theories of the term structure of interest rates explain a "flat" yield curve? A.  Segmented markets theory: Investors prefer long-term to short-term bonds. B.  Liquidity premium theory: The liquidity premium on medium- and long-term bonds equals zero and expected future short-term rates are constant. C.  Expectations theory: Interest rates are expected to remain steady in the future. D.  Expectations theory: Interest rates are equally likely to fall or rise in the future. E.  Preferred habitat theory: Interest rates are expected to fall moderately in the future.

Explanation / Answer

(C) Expectation Theory : interest rates are expected to remain steady in the future.

Because, the slope of the yield curve depends on individuals expectations of the future direction of interest rates. The yield curve will slope upward if people expect interest rates to rise; the yield curve will slope downward if people expect interest rates to fall; and the yield curve will be flat if people believe interest rates to stay the same. So interest rate cannot remain steady.

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