The real risk-free rate is expected to remain constant at 3% in the future,a 2% rate of inflation is expected for the next 2 years,after which inflation is expected to increase to 4%,and there is a positive maturity risk premium that increases with years to maturity.Given these conditions,which of the following statements is CORRECT?
A) The yield on a 2-year T-bond must exceed that on a 5-year T-bond.
B) The yield on a 5-year Treasury bond must exceed that on a 2-year Treasury bond.
C) The yield on a 7-year Treasury bond must exceed that of a 5-year corporate bond.
D) The conditions in the problem cannot all be true--they are internally inconsistent.
E) The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope.

Question

Quizplus · Accepted Answer

According to the expectations theory, the interest rate on a long-term bond should equal the average of the short-term interest rates expected to occur over the life of the long-term bond. Therefore, the yield on a 5-year Treasury bond should be equal to the average of the short-term interest rates expected over the next 5 years, which is 2.5%. On the other hand, the yield on a 2-year Treasury bond should be equal to the average of the short-term interest rates expected over the next 2 years, which is 2%. Therefore, the yield on a 5-year Treasury bond should be higher than that on a 2-year Treasury bond.

Option A is incorrect because it is the opposite of the correct statement.

Option C cannot be determined from the information provided.

Option D is incorrect because the conditions are not internally inconsistent.

Option E cannot be determined from the information provided.

The Real Risk-Free Rate Is Expected to Remain Constant at 3