Question

The real risk-free rate of interest is expected to remain constant at 2.5% 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?

a. Since the pure expectations theory holds, all 5-year corporate bonds must have the same yield as 5-year Treasury bonds.

b. The 5-year Treasury bond must have a higher yield than the 3-year corporate bond.

c. The 5-year corporate bond must have a higher yield than the 3-year corporate bond.

d. Since the pure expectations theory holds, the 5-year corporate bond must have the same yield as the 3-year corporate bond.

e. Since the pure expectations theory holds, all 3-year Treasury bonds must have higher yields than all 5-year Treasury bonds.

Answer 1

c. The 5-year corporate bond must have a higher yield than the 3-year corporate bond.

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