The Real Risk-Free Rate Is Expected to Remain Constant at 3

question 9

Multiple Choice

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.

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Definitions:

Common Stock

Equity ownership in a corporation, with rights to vote on corporate matters and receive dividends.

Accounts Payable

Obligations or amounts owed by a business to suppliers or vendors for goods and services received.

Inventory

The goods and materials a business holds for the ultimate goal of resale or production.

Amortization

The process of spreading out a loan into a series of fixed payments over time, which includes both principal and interest.