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Assume that you would like to invest a certain amount of money for two years and considers investing in a one - year bond that
Assume that you would like to invest a certain amount of money for two years and considers
investing in a oneyear bond that pays percent and a twoyear bond that pays percent. You
are considering the following investment strategies:
Strategy A: In the first year, buy a oneyear bond that pays percent. Once that bond
matures, buy another oneyear bond that pays the forward rate.
Strategy B: In the first year, buy a twoyear bond that pays percent annually.
i If the oneyear bond purchased in year two pays percent, which strategy
should you choose? Briefly explain the rationale of your choice.
ii Calculate the oneyear forward rate one year from now that would make you
indifferent between Strategy and Strategy
iii. Now assume that you take liquidity premium into consideration. If the one
year bond purchased in year two pays percent, and the liquidity premium
on a twoyear bond is percent. Which strategy should you choose?
Briefly explain your answer.
iv Calculate the oneyear forward rate one year from now that would make you
indifferent between Strategy and Strategy this time, your calculation
should take liquidity premium for the twoyear bond into consideration.
v Assume that you now consider investing for a threeyear horizon. As of
today, a threeyear bond pays percent annually, a twoyear bond pays
percent annually. Use this information, estimate the oneyear forward rate
two years from now.
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