You wish to invest your savings of $20,000 in government securities for the next 2 years. Suppose that currently you can invest either in a security that pays interest of 8 percent per year for the next 2 years or in a security that matures in 1 year but pays only 6 percent interest. If you make the latter choice, you would then reinvest your cash flow 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 percent, as opposed to investing in the 2-year security paying 8 percent? Provide a numerical support for your answer.
- Which Theory of term structure of interest have you supported in your answer?
- Assume your required rate of return on the second-year investment is 11 percent; otherwise, you will choose to go with the 2-year security. What rationale do you offer for your preference?