Suppose that a risk-neutral investor has a choice between buying a one-year bond paying 5 percent today, a two-year bond paying 5.4 percent today, a three-year bond paying 5.8 percent today, or a four-year bond paying 6.2 percent today, if a one-year bond purchased one year from now is expected to have an interest rate of 6 percent, a one-year bond purchased two years from now is expected to have an interest rate of 7 percent, and a one-year bond purchased three years from now is expected to have an interest rate of 8 percent. Explain with the help of suitable calculations, which of the following would the investor decide to do?
a. The investor will purchase a one-year bond today, followed by three successive one-year bonds.
b. The investor will purchase a two-year bond today, followed by two successive one-year bonds.
c. The investor will purchase a three-year bond today, followed by a one-year bond.
d. The investor will purchase a four-year bond today.
What will be an ideal response?
One-year bond today, followed by three successive one-year bonds: 1.05 × 1.06 × 1.07 × 1.08 = 1.286?Two-year bond today, followed by two successive one-year bonds: 1.054 × 1.054 × 1.07 × 1.08 = 1.284?Three-year bond today, followed by a one-year bond: 1.058 × 1.058 × 1.058 × 1.08 = 1.279?Four-year bond today: 1.062 × 1.062 × 1.062 × 1.062 = 1.272?Based on the calculations it is clear that the investor would buy a one-year bond today that gives him a return of 1.286.
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What will be an ideal response?