Canadian Securities Course (CSC) Level 1 Practice Exam

What is the main focus of the expectations theory in relation to bond yields?

1. Comparing long and short-term bond yields

2. Predicting future short-term bond yields from long-term rates

3. Differences in expected returns between coupon and face value

4. Analyzing historical bond yield data

The correct answer is: Predicting future short-term bond yields from long-term rates

The expectations theory is primarily concerned with the relationship between long-term and short-term bond yields. It posits that the yield on a long-term bond is essentially an average of expected future short-term interest rates over the life of the long-term bond. Therefore, it suggests that long-term bond yields can be used to predict future short-term bond yields. This theory indicates that if investors expect short-term interest rates to rise, long-term yields will be higher to reflect these anticipated increases. Conversely, if investors expect short-term rates to fall, long-term yields will be lower. Understanding this theory allows investors to gain insights into the direction of interest rates, helping them make more informed decisions regarding bond investments. The other options, while related to bond analysis, do not directly capture the core essence of the expectations theory, which is specifically focused on predicting future short-term rates based on current long-term yields.