According to the Expectations Hypothesis, if investors believed that, for a given holding period, the average of the expected future short-term yields was greater than the long-term yield for the holding period, they would act so as to drive:
A)down the price of the short-term bond and drive up the price of the long-term bond.
B)up the price of the short-term bond and drive down the price of the long-term bond.
C)up the prices of both the short- and long-term bonds.
D)down the prices of both the short- and long-term bonds.

Question

Quizplus · Accepted Answer

According to the Expectations Hypothesis, if investors believe that short-term yields will be higher in the future, they will demand a higher return for investing in short-term bonds, and therefore the price of those bonds will decrease. On the other hand, they will be willing to accept a lower return for investing in long-term bonds, since they expect the yields to be lower in the future, and therefore the price of those bonds will increase. This means that the yield curve will become steeper, with short-term yields increasing relative to long-term yields, and the price of short-term bonds decreasing relative to the price of long-term bonds. Therefore, the correct choice is B.

According to the Expectations Hypothesis, If Investors Believed That, for a Given