Question
You have $1 million to invest on behalf of your client, who will need to cash out her investment in exactly two years. The 1-year
You have $1 million to invest on behalf of your client, who will need to cash out her investment in exactly two years. The 1-year Treasury rate is currently 1%, while the 2-year rate is 2.0%.
You instruct your client that she can choose between two investment strategies:
A. Invest in the 2-year Treasuries, thus locking in the 2-year rate of 2.0% for the next two years
B. Invest in the 1-year Treasuries, thus earning 1% over the first year, followed by some unknown yield on next-year's 1-year Treasuries over the second year.
What is the break-even forward rate on next year's 1-year Treasury that would cause the two strategies above to have the same return over the two-year holding period?
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