Question

You have $5,000 to invest for the next year and are considering three alternatives:

a. A money market fund with an average maturity of 30 days offering a current

annualized yield of 3%.

b. A one-year savings deposit at a bank offering an interest rate of 4.5%.

c. A 20-year U.S. Treasury bond offering a yield to maturity of 6% per year.

What role does your forecast of future interest rates play in your decision?

Short answer

Answer

a. Good to keep the money a for a short duration before reinvesting this after rate increase.

b. Better return than money market

c. Best for those who want to speculate on decrease in rates

Step-by-step solution

Step by Step Solution Step 1: Explanation on future forecast decision ‘a’

Since the maturity is very small i.e. 30 days, this will be good to keep the money for a very small time and reinvest when an increase in rates is foreseen. Once the rate is increased, the $5000 can be re-invested.

Explanation of future forecast decision ‘b’

The one year saving deposit in a bank may provide a higher return and less interest rate risk exposure hence it is better than the money market unless rates rise considerably.

Explanation of future forecast decision ‘c’

The long-term bond is best suited for those who want to speculate on the decrease in rates.