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The pure expectations theory assumes that a one-year bond purchased today will have the same return as a one-year bond purchased five years from now.

a) True
b) False

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Final answer:

The statement is false; the pure expectations theory actually suggests that future interest rates will affect the returns on bonds, meaning a one-year bond purchased today could have a different return than one purchased five years from now due to changing interest rates and the corresponding adjustments in bond yields.

Step-by-step explanation:

The statement that the pure expectations theory assumes a one-year bond purchased today will have the same return as a one-year bond purchased five years from now is false.

The pure expectations theory actually asserts that long-term interest rates reflect the market's expectations for future short-term rates. Therefore, if interest rates are expected to change, the return on a one-year bond purchased today could be different from the return on a one-year bond purchased in the future. This is also reflected in the bond yield, which measures the rate of return a bond is expected to pay over time, and can be different from the interest rate printed on the bond.

Considering the risk of a bond and changes in interest rates over time, as in the provided example, if a bond carries no risk and pays $80 per year on a $1,000 principal, its yield would initially be 8%. If market interest rates rise to 12%, the bond becomes less attractive, and to induce investment, its price would be lowered below face value to provide a competitive yield. This price adjustment reflects changes in expected returns based on prevailing interest rates.

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