Introduction to Finance

expec-
tations theory
contends that the shape of a yield curve refl ects investor expectations about 
future infl ation rates. If the yield curve is fl at, expectations are that the current short-term 
infl ation rate will remain essentially unchanged over time. When the yield curve is downward 
sloping, investors expect infl ation rates to be lower in the future. Recall from Figure 8.2 that 
the shape of the yield curve in March 1980 was downward sloping. Thus, investors believed 
that the double-digit infl ation rates prevailing in 1980 were expected to decline in the future. 
In contrast, a relatively fl at yield curve existed in November 1998, suggesting that investors 
expected the low infl ation rates in late 1998 to remain at low levels in the future and that the 
economy would continue to grow at a moderate rate.
An upward sloping yield curve in November 2001 (data are presented in Table 8.3 but 
not plotted in Figure 8.2) occurred at the end of the 2001 recession. The yield curve con-
tinued to be upward sloping in November 2003 as economic activity continued to increase. 
As depicted in Figure 8.3, a fl attening of the yield curve by October 2006 caused some 
concern about the possibility of a slowdown in economic activity and preceded the 2007–08 
fi nancial crisis and the 2008–09 recession. By October 2008, the yield curve, while at then 
historically low interest rates for short maturities, was upward sloping, suggesting hope for 
future recovery. However, due to a slow economic recovery, further monetary easing activ-
ities resulted in the historically low yield curves depicted for the end of December 2012 and 
December 2015.
To diff erentiate yield curve shapes in terms of equations 8.1, 8.2, and 8.3, fi rst recall that 
the liquidity and the default risk premiums are regarded as being zero for Treasury securities. 
Thus, equation 8.3 for Treasury securities becomes equation 8.1 plus a maturity risk premium 
(MRP). However, the expectations theory in its purest form also assumes the MRP to be zero. 
Given this assumption, we have reduced equation 8.3 back to equation 8.1 such that the yield 
curve refl ects only the real rate (RR) of interest plus the expectation for an infl ation premium 
(IP) over the life of the security.