You want to invest your savings of $20,000 in government securities for the next

Question

You want to invest your savings of $20,000 in government securities for the next 2 years. Currently, you can invest either in a security that pays interest of 8.0 percent per year for the next 2 years or in a security that matures in 1 year but pays only 6.0 percent interest. If you make the latter choice, you would then reinvest your savings at the end of the first year for another year. Why might you choose to make the investment in the 1-year security that pays an interest rate of only 6.0 percent, as opposed to investing in the 2-year security paying 8.0 percent? Provide numerical support for your answer. Which theory of term structure have you supported in your answer? Assume your required rate of return on the second-year investment is 11.0 percent; otherwise, you will choose to go with the 2-year security. What rationale could you offer for your preference? Why might you choose to make the investment in the 1-year security that pays an interest rate of only 6.0 percent, as opposed to investing in the 2-year security paying 8.0 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 If you choose to invest in the 1-year security, the value of your savings after the first year will be

Explanation / Answer

a) If you choose 2- year security value of savings after 2 years=$20,000*(1.08)2=20,000*1.1664=$ 23,328

If you choose 1- year security value of savings after 1 year will be=$20,000*(1.06)1=$ 21,200

If you choose 1- year security value of savings after 2 year will be=$ 21,200*(1.06)1=$ 22,472

There is greater price uncertainty or interest rate risk associated with the 2 year security as compared to 1 year security therefore the former commands a yield premium for the greater interest rate risk and volatility and less liquidity is the Liquidity preference theory which dictates that the longer term security shall have greater interest rate than the shorter term security(1 year) due to the added yield premium,

$20,000*(1.06+yield premium)2=$ 23,328

(1.06+yield premium)2=23,328/20,000=1.1664

1.06+yield premium=1.08=>yield premium=.02 or 2% is what the investors demand as per Liquidity preference theory for holding longer maturity 2 year security due to higher risk.Therefore investor might choose 1 year security than 2 year security due to lesser risk of  interest rate and price volatility as per theory and the greater liquidity that the 1 year security commands as compared to the 2 year security.

b)If you choose 2- year security value of savings after 2 years=$20,000*(1.08)2=20,000*1.1664=$ 23,328

If you choose 1- year security value of savings after 2 year will be=$ 20,000*(1.06)*(1.11)=$ 23,532

Thus you should choose 1- year security due to higher value of investment after 2 years of $ 23,532 as compared to  lower value of investment in 2 year security of $ 23,328 if second year investment return is 11%.If second year investment return is not 11% you shall choose to go with 2 year security.

Related Questions

Navigate

• Browse (All)
• Browse Y
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.