Assume that you would like to invest a certain amount of money for two years and considers

investing in a one$-$year bond that pays $5$ percent and a two$-$year bond that pays $6$ percent. You

are considering the following investment strategies:

Strategy A: In the first year, buy a one$-$year bond that pays $5$ percent. Once that bond

matures, buy another one$-$year bond that pays the forward rate.

Strategy B: In the first year, buy a two$-$year bond that pays $6$ percent annually.

i$.$ If the one$-$year bond purchased in year two pays $6\mathrm{.}5$ percent, which strategy

should you choose? Briefly explain the rationale of your choice.

ii$.$ Calculate the one$-$year forward rate one year from now that would make you

indifferent between Strategy $1$ and Strategy $2.$

iii. Now assume that you take liquidity premium into consideration. If the oneyear bond purchased in year two pays $8$ percent, and the liquidity premium

on a two$-$year bond is $0\mathrm{.}7$ percent. Which strategy should you choose?

Briefly explain your answer.

iv$.$ Calculate the one$-$year forward rate one year from now that would make you

indifferent between Strategy $1$ and Strategy $2,$ this time, your calculation

should take liquidity premium for the two$-$year bond into consideration.

v$.$ Assume that you now consider investing for a three$-$year horizon. As of

today, a three$-$year bond pays $7$ percent annually, a two$-$year bond pays $6$

percent annually. Use this information, estimate the one$-$year forward rate

two years from now.