Which of the following statements is correct?
A)The probability of default is higher on short-term bonds than on long-term bonds.
B)Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds.
C)According to the market segmentation theory, the yield curve is expected to slope downward.
D)Borrowers prefer to borrow on a short-term basis, as a result, the yield curve is downward sloping.
E)If the inflation is expected to decrease in the future, then the yield curve should have an upward slope.

Question

Quizplus · Accepted Answer

Reinvestment rate risk is the risk that the investor may not be able to reinvest cash flows from the bond at the same rate as the bond's original yield. This risk is higher on short-term bonds as the cash flows need to be reinvested more frequently, while long-term bonds allow for a longer period of uninterrupted yield.

A is incorrect as long-term bonds have a higher chance of default as the time span for default is greater. C is incorrect as the market segmentation theory assumes that the yield curve is made up of different segments for each maturity, with the interest rates determined independently by the supply and demand for each segment. D is incorrect as the shape of the yield curve is determined by the expected future path of interest rates, not borrower preferences. E is incorrect as decreasing inflation results in lower interest rates, which leads to a flatter or downward sloping yield curve.

Which of the Following Statements Is Correct