QUESTION 8 Assume that inflation is expected to decline steadily in the future,

Question

QUESTION 8 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 CORRECT, other things held constant? O It the pure expectations theory holds, the corporate yield curve must be downward sloping The expectations theory cannot hold if inflation is decreasing. OIf the pure expectations theory holds, the Treasury yiekd curve must be downward sloping O If infiation is expected to decline, there can be no maturity risk premium. O If there is a positive maturity risk premium, the Treasury yield curve must be upward sloping

Explanation / Answer

Pure expectation theory suggests that the term structure or the corporate yield is the true reflections of the expectationis of future short term rates. If the inflation is expected to decline steadily in the coming future, the corporate yield curve is expected to go for a downward sloping curve. Therefore the first option is correct.

If the pure expectation theory holds, the corporate yield curve must be downward sloping. (CORRECT Option)

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