Question

Suppose the interest rates on one-, five-, and ten-year U.S. Treasury bonds are currently $3\%,6\%$and $6\%$respectively. Investor A chooses to hold only one-year bonds, and Investor B is indifferent with regard to holding five- and ten-year bonds. How can you explain the behavior of Investors A and B?

Short answer

Investor A's choice will be steady with the segmented market theory as the return is less. Apparently investor B maximizes the expected return.

Step-by-step solution

Definition

Treasury bonds are the long-term debt securities issued by the government. It has a maturity range from three months to $30$years. There is no risk of call or default of country U Treasury debt because the country U government is one of the top players and payer in the bond market all over the world.

Explanation

Investor A chooses to hold only -year bonds could be more risk-loving than investor B, who is different between holding $5$-year and $10$-year bonds. This is because the 1-year bonds have an expected return of $3$%, while the $5$and $10$-year bonds have expected returns of $6\%$. The time to maturity is very different(more than twice between $1$and $5$-year bonds), yet the return on the$1$-year bond is half that of the $5$and $10$-year bonds.

Therefore, investor A must have been willing to take on the additional risk for $1$-year bonds, making him a risk-lover relative to the other investor. this would make investor B risk-averse because he chooses to hold the bonds with longer maturities for a return that is not proportional to the time he is investing in them.