Question

The real risk-free rate is expected to remain constant at 3% in the future, a 2% rate of inflation is expected for the next 2 years, after which inflation is expected to increase to 4%, and there is a positive maturity risk premium that increases with years to maturity. Given these conditions, which of the following statements is CORRECT?
a. The yield on a 2-year T-bond must exceed that on a 5-year T-bond.
b. The yield on a 5-year Treasury bond must exceed that on a 2-year Treasury bond.
c. The yield on a 7-year Treasury bond must exceed that of a 5-year corporate bond.
d. The conditions in the problem cannot all be true--they are internally inconsistent.
e. The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope.

Answer 1

Answer:

Option B is the correct answer

Explanation:

Option B is correct because the yield on a 5-year bond must exceed that on a 2-year Treasury bond for the following reasons.

Firstly, after two years, the expected rate of inflation will be constant after two years.

Secondly, there is also a maturity risk premium that increases with increase in the maturity of the board.

These are the two reasons why the yield on a 5 year treasury bond must exceed on a 2 year treasury bond