Suppose That the Six-Month Spot Rate Is 4

question 18

Multiple Choice

Suppose that the six-month spot rate is 4.00% and one-year spot rate is 8.10%. Additionally, suppose that you can look into a crystal ball and know for sure that six months from now that the six-month rate will be 3.60%. Finally, suppose that there is an investor who expects that six months from now, the six month rate will be 4.10%. That is, the investor expects that the six-month rate will be higher than its current level of 4.00%. How would you advise an investor who wants to buy a six-month instrument and when it matures in six months buy another six-month instrument?

• A) You would advise the investor to buy at the six-month spot rate and then in six months buy another six-month instrument because the investor will make 41.6 cents more this way for every $100 invested.
• B) It really does not matter because you will break even either way.
• C) You would advise the investor not to buy at the current rate and reinvest six month later by buying another six-month instrument because the investor will lose money compared to investing at the one-year spot rate.
• D) Using the formula for "f" we can show that the investor is correct in their assessment and thus it does not matter what the six-month spot rate will be in six months.

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Definitions:

Maximizing Utility

The process of allocating resources to obtain the highest possible satisfaction or utility.

Money Income

Refers to the total income received in the form of money, including wages, salaries, and other earnings.

Marginal Utility

The additional satisfaction or utility that a consumer derives from consuming an additional unit of a good or service.

Purchases

The act of buying goods or services.