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Short Corp just issued bonds that will mature in 10 years, and Long Corp issued bonds that will mature in 20 years. Both bonds promise to pay a
semiannual coupon, they are not callable or convertible, and
they are equally liquid. Further assume that the Treasury yield curve is based only
on the pure expectations theory. Under these conditions, which
of the following statements is CORRECT?
Oa. If Long's and Short's bonds have the same default risk, their yields must under all conditions be equal.
Ob. If the yield curve for Treasury securities is flat, Short's bond must under all conditions have the same yield as Long's bonds.
Oc. If the Treasury yield curve is upward sloping and Short has less default risk than Long, then Short's bonds must under all conditions have a lower yield
than Long's bonds.
Od. If the yield curve for Treasury securities is upward sloping, Long's bonds must under all conditions have a higher yield than Short's bonds.
Oe. If the Treasury yield curve is downward sloping, Long's bonds must under all conditions have the lower yield.



Answer :

GinnyAnswer
In this scenario, we have Short Corp and Long Corp issuing bonds with different maturities but similar characteristics. The pure expectations theory assumes that the shape of the yield curve is based solely on investors' expectations of future interest rates. 1. **Statement (Oa):** If Long's and Short's bonds have the same default risk, their yields must under all conditions be equal. - This statement is incorrect. Even if two bonds have the same default risk, their yields can differ based on other factors such as maturity, market conditions, and investor preferences. 2. **Statement (Ob):** If the yield curve for Treasury securities is flat, Short's bond must under all conditions have the same yield as Long's bonds. - This statement is incorrect. A flat yield curve does not necessarily mean that bonds with different maturities will have the same yield. The yields can still vary based on factors specific to each bond. 3. **Statement (Oc):** If the Treasury yield curve is upward sloping and Short has less default risk than Long, then Short's bonds must under all conditions have a lower yield than Long's bonds. - This statement is generally correct. In an upward-sloping yield curve scenario, lower default risk usually leads to lower yields. Therefore, Short's bonds would likely have a lower yield than Long's bonds. 4. **Statement (Od):** If the yield curve for Treasury securities is upward sloping, Long's bonds must under all conditions have a higher yield than Short's bonds. - This statement is generally correct. In an upward-sloping yield curve, longer-term bonds typically have higher yields compared to shorter-term bonds due to increased interest rate risk. 5. **Statement (Oe):** If the Treasury yield curve is downward sloping, Long's bonds must under all conditions have the lower yield. - This statement is incorrect. In a downward-sloping yield curve, shorter-term bonds may have lower yields compared to longer-term bonds due to expectations of decreasing interest rates. Therefore, based on the pure expectations theory and the relationship between yield curves, statements (Oc) and (Od) are more likely to be correct under the given conditions.