Question

Which of the following statements is CORRECT?

Select one:

a. If inflation is expected to increase, then the yield on a 2-year bond should exceed that on a 3-year bond.

b. The real risk-free rate should increase if people expect inflation to increase.

c. The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond.

d. The yield on a 3-year Treasury bond should always exceed the yield on a 2-year Treasury bond.

e. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.

Answer 1

The correct statement is (e). Corporate bonds shall be compensated for the risk involved, in the form of risk premium. Treasury bonds are risk free. Hence, for a given maturity, yield on corporate bond shall exceed that of Treasury bond.

Others:

(a) If inflation is expected to increase, longer maturities shall have higher yield. Hence given statement is not correct

(b) Inflation is not a factor in Real interest rate. Hence real risk free interest rate will not increase due to expectation., The given statement is not correct

(c) It is not necessary that yield on 3-year corporate bond  should always exceed that of 2-year bond. It will will be true only if the yield curve has upward slope due to inflation etc.. Situations may arise otherwise also. Hence the given statement is not correct.

(d) If the spot interest rate for third year at the end of two years (that is, the forward rate) is expected to remain unchanged as that of two year maturity, yield will not increase. Hence the given statement is not correct.