In your own words, explain: (i.) The primary difference between the expectations theory of the term structure and the liquidity theory of the term structure, and (ii.) Why forward rates are biased predictors of future short rates if the liquidity theory holds Solution Expectations Theory The hypothesis that long-term interest rates contain a prediction of future short-term interest rates. Expectations theory postulates that you would earn the same amount of interest by investing in a one-year bond today and rolling that investment into a new one-year bond a year later compared to buying a two-year bond today. This theory is sometimes used to explain the yield curve but has proven inaccurate in practice as interest rates tend to remain flat when the yield curve is normal. In other words, expectations theory often overstates future short-term interest rates. liquidity theory A theory stating that forward rates do not accurately predict future spot rates because forward rates are more liquid and therefore include a liquidity premium. The theory attempts to explain with the unbiased expectations theory is not borne out in real life..

1. In your own words, explain: (i.) The primary difference between the expectations theory of the
term
structure and the liquidity theory of the term structure, and (ii.) Why forward rates are biased
predictors of future
short rates if the liquidity theory holds
Solution
Expectations Theory
The hypothesis that long-term interest rates contain a prediction of future short-term interest
rates. Expectations theory postulates that you would earn the same amount of interest by
investing in a one-year bond today and rolling that investment into a new one-year bond a year
later compared to buying a two-year bond today.
This theory is sometimes used to explain the yield curve but has proven inaccurate in practice as
interest rates tend to remain flat when the yield curve is normal. In other words, expectations
theory often overstates future short-term interest rates.
liquidity theory
A theory stating that forward rates do not accurately predict future spot rates because forward
rates are more liquid and therefore include a liquidity premium. The theory attempts to explain
with the unbiased expectations theory is not borne out in real life.