Modern term structure theory states that the nominal rate on default-free securities is computed by combining a real interest rate with a(n) __________ premium. I) interest rate risk
II) liquidity
III) inflation
IV) default
A) I
B) I and III
C) II and III
D) II and IV
E) I, II and III

Question

Quizplus · Accepted Answer

According to modern term structure theory, the nominal interest rate on default-free securities is calculated by adding a real interest rate and an inflation premium. This is because inflation affects the real return that investors will receive, so an inflation premium is added to compensate for this. Interest rate risk and liquidity are factors that can affect the yield curve, but they are not directly included in the calculation of the nominal interest rate. Default risk is not relevant for default-free securities. Therefore, option B is the best choice as it includes both the real interest rate and inflation premium.

Modern Term Structure Theory States That the Nominal Rate on Default-Free