Each possible investment is perceived to have no risk of default. You plan to ma

Question

Each possible investment is perceived to have no risk of default. You plan to maintain this investment for a one-year period. The return of each investment over a one-year horizon will be about the same if interest rates do not change over the next year. However, you anticipate that the U.S. inflation rate will decline substantially over the next year, while most of the other portfolio managers in the United States expect inflation to increase slightly. a. If your expectations are correct, how will the return of each investment be affected over the one-year horizon? b. If your expectations are correct, which of the three investments should have the highest return over the one-year horizon and why? Offer possible reasons you might not select the investment that would have the highest expected return over the one-year investment horizon.

Explanation / Answer

The return on each investment over a one-year horizon will be about the same if interest rates do not change over the next year.

The portfolio contains 3 different types of investment:

1) 10-year coupon bonds issued by the US treasury,

2) 20-year zero-coupon bonds issued by the US treasury, and

3) One-year treasury securities.

A) If the expectation about the inflation is correct that the inflation rate in US will decline substantially over the next year, then the return on each investment will be rise. The reason is that there is a negative relationship between expected inflation and rate of return.

B) If the expectations are correct then one-year treasury securities will have the highest return because the maturity period is least for this investment.

One might not select the investment that would have the highest expected return over the one-year investment horizon because if the expectations are correct then in the next year the actual inflation will rise and this will have again a chain of effects on the economic variables that will affect the rate of return on the investment.

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