Question

Which of the following is an assumption of the pure expectations hypothesis? a. The maturity risk premium is positive. b. Treasury bonds have a liquidity premium. c. The maturity risk premium is zero. d. The maturity risk premium is negative.

Answer 1

Answer:

c. The maturity risk premium is zero.

Explanation:

Pure expectation theory states that the forward rate will represent expected future rate. Term structure is said to be a reflection of what the market expects future short term rates to be.

As future rates are expected to be the same as spot rates for that date, the theory is only applicable when there is no risk premium. That is the maturity risk premium is zero.