You want to invest your savings of $20 000 in government securities for the next 2 years. Currently, you can invest either in a security that pays interest of 8% per year for the next 2 years or in a security that matures in 1 year but pays only 6% 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 1-year security that pays an interest rate of only 6 %, as opposed to investing in the 2-year security paying 8%? 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 11%; otherwise, you will choose to go with the 2-year security. What rational could you offer for your preference?