Question

If the pure expectations theory of the term structure is correct, which of the following statements would be 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. Interest rate (price) risk is higher on short-term bonds, but reinvestment rate risk is higher on long-term bonds.

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

Answer 1

The correct statement according to the pure expectations theory of the term structure is choice b. An upward-sloping yield curve would not imply lower interest rates in the future. Choice d is correct that interest rate (price) risk is higher on long-term bonds, but reinvestment rate risk is higher on short-term bonds.

Step-by-step explanation:

The correct statement according to the pure expectations theory of the term structure is choice b. An upward-sloping yield curve implies that interest rates are expected to be higher in the future, not lower. 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%, it implies that the market believes 1-year rates will be 8% one year from now, not 7.5%.

Interest rate (price) risk is higher on long-term bonds as the price of a long-term bond is more sensitive to changes in interest rates. On the other hand, reinvestment rate risk is higher on short-term bonds as the interest earned must be reinvested at potentially lower rates.