Question

Coconut Pete has $100,000 that he wants to invest over the next ten years. He can invest in a series of one year maturities or invest in a ten year maturity. NO OTHER CHOICE!! Current interest rates on Treasuries for one-year maturities are 2.8% while ten year maturities are 3.2%. Pete is risk averse so he wants to invest only in Treasury securities. So he will be taking on interest rate risk. For each option, identify and describe the interest rate risk (price risk and reinvestment risk) in that investment, identify and describe what is hedged and which investment has the highest risk and which has the potential for a greater return. Which maturity should he invest in and why?

Answer 1

$100,000 -> 10 yrs

1 yr - 2.8%

10 yr - 3.2%

Option 1: Invest in 1 year maturity and reinvest next year in 1 year maturity till 10 years

Option 2: Invest in 10 years maturity once

Option 1:

A1 = P1(1+0.028) where P1 = 100000 INR and P2=A1 and so on till A10 = P10(1+0.28)

simplifying - A10 = P1(1+0.028)^10 = 100000*(1.028)^10 [Assuming interests are reinvested at each interval]

A10 = 131804.77

Option 2:

A10 = P1(1+0.032)^10 = 100000*1.032^10 = 137024.10

Since, Option 1 is reinvested at every 1 year, there is less risk in terms of uncertinity for a period of 10 years.

On the other hand, option 2 is giving 37K $ interest compared to 31.8K $ of option 1. Hence, option 2 is more profitable

One should invest in maturity for 10 year terms.