How can one invest today at the 2-year forward rate of interest?
I) By buying a 2-year bond and selling a 1-year bond with the same coupon
II) By buying a 1-year bond and selling a 2-year bond with the same coupon
III) By buying a 1-year bond and then after a year reinvesting in a further 1-year bond
a. I only
b. II only
c. III only
d. II and III only
D
To determine how to invest today at the 2-year forward rate of interest, let's break down each option and see how it relates to the concept of forward rates.
I) By buying a 2-year bond and selling a 1-year bond with the same coupon:
This option involves buying a 2-year bond, which implies an investment for the entire 2-year period. Selling a 1-year bond with the same coupon does not align with the objective of investing at the 2-year forward rate. Therefore, option I is not the correct choice.
II) By buying a 1-year bond and selling a 2-year bond with the same coupon:
This option involves buying a 1-year bond, which aligns with the objective of investing for 1 year. Selling a 2-year bond with the same coupon implies terminating an investment before it reaches maturity, potentially resulting in a loss. Hence, option II does not allow for investing at the 2-year forward rate.
III) By buying a 1-year bond and then after a year reinvesting in a further 1-year bond:
This option involves buying a 1-year bond, which aligns with the objective of investing for 1 year. After a year, reinvesting in a further 1-year bond allows for extending the investment duration to a total of 2 years. This strategy matches the concept of investing at the 2-year forward rate. Therefore, option III is the correct choice.
In conclusion, the answer is c. III only. By investing in a 1-year bond and then reinvesting after a year in another 1-year bond, you can effectively achieve the 2-year forward rate of interest.