The real risk-free rate is expected to remain constant at 3% in the future, a 2% rate of inflation is expected for the next 2 years, after which inflation is expected to increase to 4%, and there is a positive maturity risk premium that increases with years to maturity. Given these conditions, which of the following statements is CORRECT?
A. The yield on a 2-year T-bond must exceed that on a 5-year T-bond.
B. The yield on a 5-year Treasury bond must exceed that on a 2-year Treasury bond.
C. The yield on a 7-year Treasury bond must exceed that of a 5-year corporate bond.
D. The conditions in the problem cannot all be true--they are internally inconsistent.
E. The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope.
Answer: B
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