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The real risk-free rate, r*, is expected to remain constant at 3% per year.  Inflation is expected...

  1. The real risk-free rate, r*, is expected to remain constant at 3% per year.  Inflation is expected to be 2% per year forever.  Assume that the expectations theory holds; that is, there is no maturity risk premium.  Treasury securities do not require any default risk or liquidity premiums. Which of the following is most correct?
  1. The Treasury yield curve is flat and all Treasury securities yield 5%.
  2. The Treasury yield curve is upward sloping for the first 10 years, and then downward sloping.
  3. The yield curve for corporate bonds must be flat, but corporate bonds will yield more than 5 percent.
  4. Statements a and c are correct.
  5. Statements b and c are correct.
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Answer #1

rate=real risk free rate+inflation premium+maturity risk premium+default risk premium+liquidity risk premium=3%+2%+0%+0%=5%

The Treasury yield curve is flat and all Treasury securities yield 5%.

The yield curve for corporate bonds must be flat, but corporate bonds will yield more than 5 percent because of non zero default and liqudiity risk premium

Statements a and c are correct.

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