Inflation is expected to increase steadily over the next 10 years,there is a positive maturity risk premium on both Treasury and corporate bonds,and the real risk-free rate of interest is expected to remain constant.Which of the following statements is CORRECT?
A) The yield on 10-year Treasury securities must exceed the yield on 7-year Treasury securities.
B) The yield on any corporate bond must exceed the yields on all Treasury bonds.
C) The yield on 7-year corporate bonds must exceed the yield on 10-year Treasury bonds.
D) The stated conditions 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

When inflation is expected to increase steadily over the next 10 years, the yield on longer-term Treasury securities must exceed the yield on shorter-term Treasury securities. This is because investors will demand a higher yield to offset the expected inflation. Therefore, the yield on 10-year Treasury securities must exceed the yield on 7-year Treasury securities. Option A is correct. Option B is incorrect as it is too broad of a statement to say that the yield on any corporate bond must exceed the yields on all Treasury bonds. Option C is incorrect as it is the opposite of the correct statement, and option D is incorrect as the stated conditions are consistent. Option E is also incorrect, as the yield curve would have a consistent positive slope under the given conditions.

Inflation Is Expected to Increase Steadily Over the Next 10