Question

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) & (v)

(ii) only

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

(ii) & (iii)

(i), (ii) and (iv)

Answer 1

D. (i), (ii) and (iv)

i. As per market segmentation hypothesis, since Homer Simpson wants to get his returns in two years, he would prefer 2 years bonds as compared to bonds of any other maturity period.

ii. Since it is given in the question that the three and five year bonds are illiquid at all times, as per liquidity preference theory option 2 and option 3 are more riskier than option 1 and the selling price in both option 2 and option 3 could be very low due to the illiquidity, they may not be able to get sold as well.

iii. Pure expectations hypothesis assumes that the instruments of different maturities are equally attractive to investors who care only about returns. And it says that the forward rates exclusively determine the expected future rates. Since, nothing has been said about the forward rates or the expected future rates, the statement of option 3 could be true but since the option is putting forward an assertive statement, the option is incorrect. Also, since there is the liquidity problem in option 2 and option 3, the three options are more inclined to offer different returns.

iv. According to the preferred habitat theory option 1 is preferred to option 2 because the returns are expected in 2 years and the option 1 has 2 year zero coupon bond and also because option 1 is more liquid than option 2 and thus forms a part of the preferred habitat of Homer Simpson. Option 2 however might be preferred if Homer Simpson believes that the three year spot rate in 2 years time is less than f(2,5) in which case there would be a capital gain arising due to decrease in yield rates at the end of the 2 years. To be certain however, the liquidity cost needs to be taken into consideration.

v. Option 1 is preferred to option 3 according to preferred habitat theory but information on the rates at the end of 2 years would be required in order to justify the second statement that 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).