Question

Bond A is a​ one-year instrument and Bond B is a​ two-year instrument. The bonds have very similar default risk and income tax treatment.​ Currently, the following yields exist on these bonds.

Bond	Yield
A	2.75​%
B	3.75​%

If​ (holding all else​ equal) the interest rate that investors expect on​ one-year instruments next year suddenly

increases

to

5.50​%,

investors will become

▼

more likely to sellmore likely to sell

more likely to buymore likely to buy

neither more likely to buy nor more likely to sellneither more likely to buy nor more likely to sell

​two-year bonds today. This will cause the yield on​ two-year bonds today to

▼

increaseincrease

remain unchangedremain unchanged

decreasedecrease

.

Answer 1

1) More likely to sell two year bonds today.

( investors will find one year instruments more attractive since their expected yield in higher than two year instruments now. As a result, they more likely to sell two year instruments today so that they can purchase one year instruments.)

2) Increase

( we already saw that a rise in the expected yield of one year instrument will result in a investors selling them. This means that their supply increase . There will be less demand compared to supply. As a result, price of one year instrument will fall and it will be accompanied by a rise in yield.)