Question

You want to invest your savings of ​$23,000 in government securities for the next 2 years.​ Currently, you can invest either in a security that pays interest of 7.5 percent per year for the next 2 years or in a security that matures in 1 year but pays only 5.6 percent interest. If you make the latter​ choice, you would then reinvest your savings at the end of the first year for another year.

a. Why might you choose to make the investment in the 1​-year security that pays an interest rate of only 5.6 percent, as opposed to investing in the

2-year security paying 7.5 percent? Provide numerical support for your answer. Which theory of term structure have you supported in your​ answer?

b. Assume your required rate of return on the​ second-year investment is 10.4 percent; otherwise, you will choose to go with the 2-year

security. What rationale could you offer for your​ preference?

a. Why might you choose to make the investment in the 1​-year security that pays an interest rate of only 5.6 percent, as opposed to investing in the 2-year security paying 7.5

​percent? Provide numerical support for your answer. Which theory of term structure have you supported in your​ answer?

If you choose the 2-year security, the value of your savings after the second year will be ​$_ (round to the nearest dollar)

Answer 1

Year 0 Year 1 Year 2 Security 1 23000 24725 26579.38 Security 2 23000 24288 9.43% we might choose Security 2, if we expect the interest rate in the market to increase. This will allow us to reinvest at a higher rate. The 2nd year interest rate has to be atleast 9.43% to break even with security 1 According to unbiased expected theory, the curve reflects market's current expectation of future short term rates If the required rate of return is 10.4%, which is higher than the 9.43% The higher required rate of return would be due to the future uncertainty and risk associated with 2nd year interest rate. 2 year security value at the end of 2nd year will be $26579