Suppose two corporate bonds with similar risk pay different rates of return. The process of arbitrage should
A) not affect their rates of return.
B) increase the return on the asset with the higher rate of return as the demand for it increases.
C) increase the gap between the two rates of return.
D) eventually equalize their rates of return.

Question

Quizplus · Accepted Answer

Arbitrage involves buying the lower-yielding bond and selling the higher-yielding bond, which should drive up demand for the lower-yielding bond and increase its price, while decreasing demand for the higher-yielding bond and decreasing its price. This process will eventually lead to both bonds having the same rate of return, eliminating any opportunity for arbitrage. Therefore, D is the correct answer.

Suppose Two Corporate Bonds with Similar Risk Pay Different Rates