SHORT-TERM DEFAULT-FREE INTEREST RATES TEND TO BE VERY HEAVILY INFLUENCED BY THE INFLATION ENVIRONMENT AND INFLATION EXPECTATIONS OVER TIME

9. B is correct. Short-term default-free interest rates tend to be very heavily influenced by the

inflation environment and inflation expectations over time. The greater uncertainty about the

real value of the bond’s payoff will cause investors to demand a premium in compensation

for this uncertainty and will cause the discrepancy in bond pricing. The break-even inflation

rate incorporates both premiums for expectations about inflation and for the uncertainty of

the future inflation environment. Section 4.1-4.4. LO.e.