University of Central Florida (UCF) FIN3403 Business Finance Practice Exam 1

The Unbiased Expectations Theory posits that the term structure of interest rates is primarily determined by investors' expectations regarding future interest rates. This theory suggests that the yields on long-term securities are a reflection of the average expected future short-term interest rates over that period. Therefore, if investors expect interest rates to rise, the yield curve will slope upwards, indicating higher future rates, while if they expect rates to fall, the yield curve will slope downwards.

This concept emphasizes that investors base their decisions on what they expect to happen in the future, making their expectations a driving factor in the formation of the term structure. In contrast, other theories such as Liquidity Preference Theory and Market Segmentation Theory have different foundational premises concerning risk and market segments that do not focus primarily on future expectations. These theories consider factors like the preference for liquidity and the existence of different market segments, respectively, rather than a straightforward expectation of future interest rates, hence they provide alternative views on interest rate determination.