Today is t=0. David is considering investing in a two-year zero-coupon Treasury note with a face amount of $10,000. The price is $8,900 today. David’s financial adviser tells him that the rate of return on the Treasury note is relatively low compared to other investment opportunities. He offers David the alternative investment of a $10,000 two-year IBM bond with a 5% coupon rate (annual payment) and a price of $8,800 today. At the same time, a friend is opening a new business and asks David to lend him $10,000. The friend promises to pay David $6,000 at t=1 and $7,000 at t=2. Assume that David will be able to reinvest any cash received at t=1 at a reinvestment rate of 6%.
a. Calculate the future value of the three proposed investments at t=2.
b. Derive the expected rate of return of the three investments.
c. Discuss the risk of each proposed investment.
d. If David abhors risk, which investment should he undertake? Why
Today is t=0. David is considering investing in a two-year zero-coupon
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