Question

3.

Homer Simpson is considering three investment options. Option 1 involves investing in a zero coupon bond for two years. Option 2 involves investing in a five-year zero coupon bond and then selling that bond in two-year’s time. Option 3 involves investing in a one year zero coupon bond and then investing in another one year zero coupon bond when the first zero coupon bond matures. Assume for this question that three and five year bonds are illiquid at all times. Which of the following are correct?

i. According to the market segmentation hypothesis, Option 1 would be preferred to Option 3.
ii. According to the liquidity premium hypothesis, Option 2 is riskier than Option 1 because the selling price at t=2 could be very low because three year bonds are illiquid.
iii. According to the pure expectations hypothesis, the actual return from all three strategies is identical.
iv. According to the preferred habitat theory, Option 1 is preferred to Option 2 but Option 2 may be preferred if Homer Simpson believes that the three-year spot rate in two-year’s time is less than f(2,5)
v. According to the preferred habitat theory, Option 1 is preferred to Option 3 but Option 3 may be preferred to Option 1 if Homer Simpson believes that the one-year spot rate in one year’s time is less than f(1,2).

The correct answer is:

Group of answer choices

(ii) & (iii)

(ii) only

(i), (ii), (iii) and (iv)

(ii) & (iii) & (v)

(i), (ii) and (iv)

Answer 1

(i), (ii), (iii) and (iv) - Correct option

Explanation

Market segmentation hypothesis - There is no relation between bonds with different maturity periods. The investor will consider only based on maturity. In this question the investor prefer 2 year maturity and hence option 1 is preferred to option 3. Statement i. is correct

Liqidity premium hypothesis - As the name suggest, the investor prefer liquid investments and option 2 is illiquid all times and hence statement ii. is correct

Pure expectation hypothesis - The bonds are indifferent to the maturity in this hypothesis and the investor doesn't find it riskier for long term bond. Hence the actual return are identical. statement iii is correct

Preferred habit theory - In order to invest in different bond and compromise on maturity if the return is higher than preferred one. In this option, 3year spot rate is less than f(2,5), the return is higher and hence preferred. Statement iv is correct.

In the next option, the spot rate is lower after one year than future rate and hence result in lower return. Statement v is not correct.