Question

Assume that there are only two U.S. treasury bonds in the market. Bond A has a 2-year maturity and Bond B has a 10-year maturity.

If the yield curve is "downard sloping," which of the following must be true?

Check all that apply:

Purchasing Bond A and holding it to maturity will produce a higher cumulative total return than purchasing Bond B and holding it to maturity.

Purchasing Bond A and holding it to maturity will produce a higher average annual return than purchasing Bond B and holding it to maturity.

Purchasing Bond A and holding it to maturity two years later will generate a higher return than purchasing Bond B and selling it two years later.

Purchasing Bond A and selling it one year later will generate a higher return than purchasing Bond B and selling it one year later.

Answer 1

The correct statements are 2,3 and 4

The downward yield represents the situation when the shorter term duration securities have higher yield rate than the longer term duration of securities where duration means the years to maturity. This is because of the risk and the liquidity premium that the investors are expecting on the securities.

The Yield on shorter term securities will have higher yield than long term rate then it means that the yield on holding of security of 1 and 2 year will be greater for short term securities also the average return would be greater over long term security.

For example : Yield on Short term Bond - 8.0% [2 years maturity]

Yield on long term bond - 7.0% [10 years maturity]

So, The Benefit of holding the security for 1 or 2 year would be greater for Short term bond also the average rate of return.