According to modern term structure theory, which of the following factors is most likely to determine whether the term structure of interest rates is upward or downward sloping?
A) The default premium.
B) The inflation premium.
C) The interest rate risk premium.
D) The nominal interest rate.
E) The liquidity premium.

Question

Quizplus · Accepted Answer

According to modern term structure theory, the most important factor that determines whether the term structure of interest rates is upward or downward sloping is the inflation premium. This premium reflects the expected inflation rate over the life of a bond or other fixed-income security. If investors expect inflation to rise in the future, they will demand higher rates of return on longer-term bonds, which will cause the term structure to be upward sloping. Conversely, if investors expect inflation to fall in the future, they will be willing to accept lower rates of return on longer-term bonds, which will result in a downward-sloping term structure. The other factors listed (default premium, interest rate risk premium, nominal interest rate, and liquidity premium) can also affect the shape of the term structure, but none are considered to be as important as the inflation premium.

According to Modern Term Structure Theory, Which of the Following