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 3-year maturity and one with a 5-year maturity. Both have the same default and liquidity risks. Given these assumptions, which of these statements is CORRECT?
Please list the reasons why.
As the Yield curve is upward sloping, the yield is higher for greater maturity bonds. Also, the risks for the 3 year and 5 year corporate bonds are the same. However, we do not have any idea about the default spread between Treasury bonds and the Corporate bonds. Generally the yield of corporate bonds is higher than treasury rates.
a) is incorrect as 5year Corporate bonds and 5 year Treasury bonds yields cannot be same.
b) Yield of 5 year treasury bonds cannot be compared with yields of 3 year corporate bonds as we do not know the default spread. So this option is incorrect
c) is incorrect because the 3 year treasury bonds will have lower interest rates as compared to 5 year treasury bonds because of upward sloping yield curve
d) is incorrect because 5 year corporate bonds will have higher interest rates as compared to 3 year corporate bonds because of upward sloping yield curve
e) is correct because 5 year corporate bonds will have higher interest rates as compared to 3 year corporate bonds because of upward sloping yield curve
The real risk-free rate of interest is expected to remain constant at 3% for the foreseeable...
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