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:

B) The yield on a 5-year Treasury bond must exceed that on a 2-year Treasury bond.

Explanation:

The yield on 5-year Treasury bond must be higher than a 2-year Treasury bond. This is because the expected inflation rate after 2-years will be constant at 4% and there is also a maturity risk premium which increase with the increase in maturity of the bond. Therefore, the correct answer is option B.