Assume that inflation is expected to decline steadily in the future, but that th
ID: 2787141 • Letter: A
Question
Assume that inflation is expected to decline steadily in the future, but that the real risk-free rate, r*, will remain constant. Which of the following statements is CORRECT, other things held constant?
If inflation is expected to decline, there can be no maturity risk premium.
If the pure expectations theory holds, the corporate yield curve must be downward sloping.
If there is a positive maturity risk premium, the Treasury yield curve must be upward sloping.
If the pure expectations theory holds, the Treasury yield curve must be downward sloping.
The expectations theory cannot hold if inflation is decreasing.
Explanation / Answer
If inflation is expected to decline, there can be no maturity risk premium.
Answer: FALSE, as with less inflation, the rate of return will reduce and subsequently coupons may become higher. Hence, it may sell at the premium.
If the pure expectations theory holds, the corporate yield curve must be downward sloping.
Answer: FALSE, it will be upward sloping as with higher term, interest will be higher.
If there is a positive maturity risk premium, the Treasury yield curve must be upward sloping.
Answer: CORRECT, Treasury yield curve will be upward sloping only.
If the pure expectations theory holds, the Treasury yield curve must be downward sloping.
Answer: FALSE, it will be upward sloping as with higher term, interest will be higher.
The expectations theory cannot hold if inflation is decreasing.
Answer: FALSE: it will hold good even if inflation will decrease or increase as it is independent and theoretical.