The real risk-free rate of interest is expected to remain constant at 3% for the foreseeable future.However,inflation is expected to increase steadily over the next 30 years,so the Treasury yield curve has an upward slope.Assume that the pure expectations theory holds.You are also considering two corporate bonds,one with a 5-year maturity and one with a 10-year maturity.Both have the same default and liquidity risks.Given these assumptions,which of these statements is CORRECT?
A) Since the pure expectations theory holds,the 10-year corporate bond must have the same yield as the 5-year corporate bond.
B) Since the pure expectations theory holds,all 5-year Treasury bonds must have higher yields than all 10-year Treasury bonds.
C) Since the pure expectations theory holds,all 10-year corporate bonds must have the same yield as 10-year Treasury bonds.
D) The 10-year Treasury bond must have a higher yield than the 5-year corporate bond.
E) The 10-year corporate bond must have a higher yield than the 5-year corporate bond.

Question

Quizplus · Accepted Answer

According to the pure expectations theory, investors will expect to be compensated for an increase in inflation over time. This means that bonds with longer maturities must have higher yields than those with shorter maturities. Therefore, the 10-year corporate bond must have a higher yield than the 5-year corporate bond. Choices A, B, and C are incorrect because they do not take into account the effect of the increasing inflation on the yield curve, and choice D is incorrect because it assumes that the treasury yield curve will remain constant, which is not a valid assumption in this scenario.

The Real Risk-Free Rate of Interest Is Expected to Remain