(Term Structure of Interest Rates) You want to invest your savings of $30,000 in
government securities for the next two years. At the present, you can invest either in
a security that pays interest of 8% per year for the next two years or in a security that
matures in one year and pays 10 percent interest. If you make the latter choice, 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 one-year security that
pays an interest rate of 10 percent, as opposed to investing in the two-year
security paying 8 percent? Provide numerical support for your answer. Which
theory of term structure have you supported in your answer?
b. Assume your required rate of return on the second-year investment is 7
percent; otherwise, you will choose to go with the two-year security. What
rationale could you offer for your preference?
