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 two-year CD 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?

Answer 1

Forecast of future interest rate is the most important factor besides liquidity and default factors. When you are deciding to invest for future you would like to invest in an instrument which provides you the highest interest rate, higher interest rate means the future value of your investment would be higher. If we ignore the liquidity requirement here or the obligation to withdraw the fund in near future then among all the three options it seems that the 20 year US treasury is providing the highest yield of 6% per year which is far more than the money market annualized yield of 3% but again if we take into account the liquidity requirement that the investor might want to sell the investment in the short term to meet financial obligation then the money market fund might be better but if we keep these factors constant (liquidity, default and maturity) then higher the interest rate higher will be the future value. Also, these factors such as liquidity, maturity and default play an important role in estimation of required rate on any instrument, higher the risk higher will be the required interest rate.