Joe Has Two Investment Opportunities

question 78

Essay

Joe has two investment opportunities. He can buy a two-year security today, hold onto it for two years, and then cash it in. The interest rate on the two-year security is 8%. Or Joe can buy a one-year security today. At the end of the year he can cash in the one-year security and buy another one-year security. The interest rate on the first one-year security is 7%. Explain under what circumstances it would be preferable for Joe to:
(a) buy the two-year security;
(b) buy the two one-year securities.
(c) Under what circumstance would Joe be indifferent between the two-year security and the two one-year securities?

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Definitions:

Compressed

The state of being pressed into less space or condensed under pressure.

New Pressure

A term referring to the stress or urgency of a situation, or in a scientific context, the change in the force exerted by a fluid per unit area.

Expanded

Increased in volume or size, often by the introduction of air or in response to heat.

New Pressure

An unspecified or novel force applied uniformly over a surface, measured typically in units such as pascals.