Canadian Securities Course (CSC) Level 1 Practice Exam

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

1. Expectations theory

2. Market segmentation theory

3. Liquidity preference theory

4. Real rate theory

The correct answer is: Expectations theory

The correct answer is A. Expectations theory. This theory suggests that current long-term rates predict future short-term rates. According to the Expectations theory, long-term interest rates are an average of current short-term interest rates expected to occur in the future. This implies that investors are indifferent between investing in short-term securities or rolling over their investments in short-term securities. Option B, Market segmentation theory, suggests that the market is segmented into different sectors based on the maturity of the securities. Option C, Liquidity preference theory, posits that investors prefer short-term securities over long-term securities due to the added risk associated with holding long-term bonds. Option D, Real rate theory, focuses on the relationship between real interest rates and inflation expectations, and it does not directly relate to predicting future short-term rates based on current long-term rates.