Suppose that you have $1,000 to invest in the bond market on January 1, 2012. You could buy a one-year bond with an interest rate of 4%, a two-year bond with an interest rate of 5%, a three-year bond with an interest rate of 5.5%, or a four-year bond with an interest rate of 6%.
You expect interest rates on one-year bonds in the future to be 6.5% on January 1, 2013, 7% on January 1, 2014, and 9% on January 1, 2015. You want to hold your investment until January 1, 2016.
Which of the following investment alternatives gives you the highest return by 2016:
(a) Buy a four-year bond on January 1, 2012;
(b) buy a three-year bond January 1, 2012, and a one-year bond January 1, 2015;
(c) buy a two-year bond January 1, 2012, a one-year bond January 1, 2014, and another one-year bond January 1, 2015;
(d) buy a one-year bond January 1, 2012, and then additional one-year bonds on the first days of 2013, 2014, and 2015?