( Term structure of interest rates ) You want to invest your savings of $30,000 in government...
Question:
(Term structure of interest rates) You want to invest your savings of $30,000 in government securities for the next 2 years.Currently, you can invest either in a security that pays interest of 7.8 percent per year for the next 2 years or in a security that matures in 1
year but pays only 6.4 percent interest. If you make the latterchoice, you would then reinvest your savings at the end of the first year for another year.
a. Why might you choose to make the investment in the 1-year security that pays an interest rate of only 6.4 percent, as opposed to investing in the 2-year security paying 7.8 percent? Provide numerical support for your answer. Which theory of term structure have you supported in youranswer?
b. Assume your required rate of return on thesecond-year investment is 10.2 percent; otherwise, you will choose to go with the 2-year security. What rationale could you offer for yourpreference?
a. Why might you choose to make the investment in the 1-year security that pays an interest rate of only 6.4 percent, as opposed to investing in the 2-year security paying 7.8 percent? Provide numerical support for your answer. Which theory of term structure have you supported in youranswer?
If you choose the 2-year security, the value of your savings after the second year will be $. (Round to the nearestdollar.)
If you choose to invest in the 1-year security, the value of your savings after the first year will be $. (Round to the nearestdollar.)
How much interest must the 1-year security earn after its renewal in the second year in order for your account to equal the 2-year investment?
To do as well as you would with the firstchoice, during the second year the 1-year security would have to earn $. (Round to the nearestdollar.)
In order for the investment in the 1-year security to equal the 2-year investment, how much should the renewal rate on the 1-year securitybe?
The required interest rate during the second year is
%. (Round to one decimalplace.)
"Thus, you would invest in the 1-year security paying 6.4 % only if you believed you could earn at least 9.2 % in the second year on a security issued at the beginning of the second year. The foregoing logic is based on the expectations theory of term structure of interestrates."
Is the above statement true orfalse?
False
True
b. Assume your required rate of return on thesecond-year investment is 10.2 percent; otherwise, you will choose to go with the 2-year security. What rationale could you offer for yourpreference?
"If you require an 10.2% rate on the secondone-year investment, then the expectations theory is not explaining fully the term structure of interest rates. The expectations theory suggests you should accept 9.2 % in year two.Thus, you are requiring aliquidity-risk premium on thesecond-year investment to compensate for the uncertainty of the future interest rates in yeartwo."
Is the above statement true orfalse?
False
True
Foundations of Finance The Logic and Practice of Financial Management
ISBN: 978-0132994873
8th edition
Authors: Arthur J. Keown, John D. Martin, J. William Petty