The Real Risk-Free Rate of Interest Is Expected to Remain

question 26

Multiple Choice

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 5-year maturity and one with a 10-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,the 10-year corporate bond must have the same yield as the 5-year corporate bond.
• B) Since the pure expectations theory holds,all 5-year Treasury bonds must have higher yields than all 10-year Treasury bonds.
• C) Since the pure expectations theory holds,all 10-year corporate bonds must have the same yield as 10-year Treasury bonds.
• D) The 10-year Treasury bond must have a higher yield than the 5-year corporate bond.
• E) The 10-year corporate bond must have a higher yield than the 5-year corporate bond.

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Definitions:

Retained Earnings

The portion of net income not distributed to shareholders but reserved by the company to reinvest in its core business or to pay debt.

Du Pont Identity

A financial analysis framework that breaks down Return on Equity (ROE) into three component parts—profit margin, asset turnover, and financial leverage—providing insights into a company's operational efficiency.

ROE

Return on Equity, an indicator of financial efficiency determined by dividing the net income by the equity of shareholders.