As a portfolio manager for an insurance company, you are about to invest funds in one of three possible investments: (1) 10-year coupon bonds issued by the U.S. Treasury, (2) 20-year zero-coupon bonds issued by the Treasury, or (3) one-year Treasury securities. Each possible investment is perceived to have no risk of default. You plan to maintain this investment for a one-year period. The return of each investment over a one-year horizon would be about the same if interest rates do not change over the next year. However, you anticipate that the U.S. inflation rate will decline substantially over the next year, while most of the other portfolio managers in the United States expect inflation to increase slightly.
a. If your expectations are correct, how will the return of each investment be affected over a one-year horizon?
b. If your expectations are correct, which of the three investments should have the highest return over the one-year horizon? Why?
c. Offer one reason why you might not select the investment that would have the highest expected return over the one-year investment horizon.
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