5. Pure expectations theory: Multi-year periods

Caroline would like to invest a certain amount of money for three years and considers investing in (1) a one-year bond that pays 4 percent, followed by a two-year bond that pays the forward rate, or (2) a three-year bond that pays 9 percent in each of the next three years. Caroline is considering the following investment strategies:

	Strategy A: Buy a one-year bond that pays 4 percent in year one, then buys a two-year bond that pays the two-year forward rate in years two and three.
	Strategy B: Buy a three-year bond that pays 9 percent in each of the next three years.

If the two-year bond purchased one year from now pays 8 percent annually, Caroline will choose Strategy ____

Which of the following describes conditions under which Caroline would be indifferent between Strategy A and Strategy B?

The rate on the two-year bond purchased one year from now is 10.662 percent.

The rate on the two-year bond purchased one year from now is 11.589 percent.

The rate on the two-year bond purchased one year from now is 12.632 percent.

The rate on the two-year bond purchased one year from now is 9.967 percent.