Canadian Securities Course (CSC) Practice Exam

Which theory suggests that current long-term interest rates predict future short-term rates?

1. Expectations theory

2. Liquidity preference theory

3. Market segmentation theory

4. Efficient market theory

The correct answer is: Expectations theory

The expectations theory states that the shape of the yield curve is determined by the market's expectations of future interest rates. It suggests that long-term interest rates reflect the expected future short-term interest rates. This means that when investors have high expectations of future short-term rates, they will demand higher yields on long-term bonds, causing the yield curve to slope upwards. In contrast, the liquidity preference theory suggests that investors prefer short-term bonds because they are more liquid and have less risk. The market segmentation theory states that the bond market is divided into different sectors, with investors only investing in a specific maturity range based on their preferences and needs. The efficient market theory states that asset prices reflect all available information, making it impossible to consistently predict future interest rates. Therefore, the expectations theory is the most appropriate answer to the question.