Assume the Following: the Real Risk-Free Rate,r*,is Expected to Remain

question 18

Multiple Choice

Assume the following: The real risk-free rate,r*,is expected to remain constant at 3%.Inflation is expected to be 3% next year and then to be constant at 2% a year thereafter.The maturity risk premium is zero.Given this information,which of the following statements is CORRECT?

• A) The yield curve for U.S.Treasury securities will be upward sloping.
• B) A 5-year corporate bond must have a lower yield than a 5-year Treasury security.
• C) A 5-year corporate bond must have a lower yield than a 7-year Treasury security.
• D) The real risk-free rate cannot be constant if inflation is not expected to remain constant.
• E) This problem assumed a zero maturity risk premium,but that is probably not valid in the real world.

---

Definitions:

Nominal Interest Rate

The percentage rate at which interest is charged or paid on a loan or investment, not adjusted for inflation.

Inflation Rate

The upward trajectory of prices for goods and services, causing a consequent decline in how much one can purchase.

Purchasing Power

The purchasing power of a currency, showing the quantity of goods or services one unit can acquire.

Nominal Interest Rate

The interest rate before adjustments for inflation, representing the face value of financial transactions.