I can invest for two years today in a two-year bond, and get two years at the tw

Question

I can invest for two years today in a two-year bond, and get two years at the two-year rate. Or, I can invest for one year at the one-year rate, and reinvest my proceeds after a year at the one-year rate that is available at the time my one-year bond matures (we call this the one year forward rate. Now, since I can use derivatives to lock in the one year forward rate today, .. Would I rather invest for two years at the two year rate, or invest for one year at the one year rate and reinvest for another year at the one year forward rate? Explain your reasons about what I should do.

Explanation / Answer

Though both option is equally good but it always advisable to go with shorter duration investment and then renew it in this way one can take advanatage of the change in interest rate. But it can gnerate loss or profit as per the movement of the interest rate but once can hedge it using derivatives like future and forward.

In this way one should select second option where invest for one year and reinvest for another year at teh one year forward rate in that way investor can take the advantage of change in interest rate and hedge against the adverse movement of the interest rate.

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