You want to invest your savings of $30,000 in government securities in for the n

Question

You want to invest your savings of $30,000 in government securities in for the next two years.Currently,youcan invest either in a security that pays 8.1 percent per year for two years. Or in a security that matures in 1 year but pays 6.3 percent interest if you make the latter choice you would then invest your savings at the end of the first year for another year.

A.Why might you choose the to make an investment in the 1-year security.Which theory of term structure have you supported in your answer?

b.Assume your required rate of return on the second year investment is 10.9 percent,otherwise you would go with the 2 year security. What rationale could you offer for your preference?

If you choose the 2-year security the value of your savings after the second year would be ?

Explanation / Answer

a)

If you invest in the two-year security, you will have saved $34,992 ($30,000 x 1.08 x 1.08) by the end of the second year. Investing in the one-year security, you would have saved $31800 ($30,000 x 1.06) by the end of the first year. To do as well as you would with the first choice, you would have to earn $3192 in interest in the second year ($34,992 - $31800). That means you would have to earn 10.9% ($3192/$31800) on the investment bought in the second year, if you want to be as well off in the second year as you would be from buying the two-year security. Thus, you would invest in the one-year security paying 6% only if you believed you could earn at least 10% in the second year on a security issued at the beginning of the second year. The foregoing logic is based on the expectations theory of term structure of interest rates.

b)

If you require a 10.9% rate on the second one-year investment, then the expectations theory is explaining fully the term structure of interest rates. The expectations theory suggests you should accept 10.9% in year two.

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