Suppose that a risk-neutral investor has a choice between buying a one-year bond

Question

Suppose that a risk-neutral investor has a choice between buying a one-year bond paying 4 percent today, a two-year bond paying 5 percent today, a three-year bond paying 5.3 percent today, or a four-year bond paying 5.8 percent today, if a one-year bond purchased one year from now is expected to have an interest rate of 5.5 percent, a one-year bond purchased two years from now is expected to have an interest rate of 6 percent, and a one-year bond purchased three years from now is expected to have an interest rate of 7 percent. If the investor has a 4 year time horizon, which combination would the investor buy?   To receive full credit, you must show all calculations.

Explanation / Answer

Since investor has 4 year time horizon, we can check all the combinations

Best combination for investor is to buy 4 yr bond at 5.8% interest

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