Question

If the pure expectations theory of the term structure is correct, which of the following statements is CORRECT?

A. An upward sloping yield curve would imply that interest rates are expected to be lower in the future.

B. If a 1-year Treasury bill has a yield to maturity of 7% and a 2-year Treasury bill has a yield to maturity of 8%, this would imply the market believes that 1-year rates will be 7.5% one year from now.

C. The yield on a 5-year corporate bond should always exceed the yield on a 3-year Treasury bond.

D. Interest rate price risk is higher on long-term bonds, but reinvestment rate risk is higher on short-term bonds.

E. Interest rate price risk is higher on short-term bonds, but reinvestment rate risk is higher on long-term bonds.

Answer 1

correct statement : D. Interest rate price risk is higher on long-term bonds, but reinvestment rate risk is higher on short-term bonds.

A : wrong : because upward sloping curve implies higher interest rate

B : wrong : because 2f1 = (1 +1r2)^2/(1+1r1)^1 - 1 = (1 +0.08)^2/(1+0.07)^1 - 1 = 0.09 = 9%

C : wrong : it depends on quality of corporate bond. if it it issued from a very good company, it may be equal to T bond as well

E : wrong : Reinvestment risk is higher for short term bonds and not for long term bonds. Interest rate risk is higher for long term bonds.