You are a financial analyst for the CMC Corporation. This corporation predicts changes in the economy, such as interest rates, retail trends, and unemployment. Your job is to educate incoming analyst...

Pure expectations theory
It is the most popular and well accepted theory that tries to explain the shape of the yield curve.
It tells that the shape of the yield curve will be as per the investor’s future expectations. Let’s
explain it with the help of an example, suppose that the yield curve of a bond is flat with all the
maturities selling to yield of 6%. Now, let’s suppose investors expect that it is going to be 8% in
future. Therefore, investors two year horizon can build their strategy in the following way:-
1. We could buy two-year bonds and earn 6% over two years OR
2. We could buy a one-year bond of 6% and roll it into another one-year bond of 8%
and earn 7% over the two years.
3. Clearly, rational investors may be expected to choose the second alternative.

As a result the demand for 1 year bond will increase but its price fall and vice versa for the two
years bond. Hence, this theory gives the shape of the curve as per following explanation that the
shape of the yield curve will depends on investors future expectations about the bond market.
Example: Lets understand with an example that what will be the two years bond rate for the
below bond which pays the interest semiannually.
Year Period
Spot yield
1 3.0%
1 2 3.4%
3 3.8%
2 4 4.2%
5 4.8%
3 6 5.4%
7 5.8%
4 8 6.4%
9 6.8%
5 10 ...