Question

Ric wants to invest in government securities that promise to pay $1,000 at maturity. The opportunity cost (interest rate) of holding the security is 6.80%. Assuming that both investments have equal risk and Eric's investment time horizon is flexible, which of the following investment options is priced lower?
An investment that matures in four years
An investment that matures in five years

Answer 1

Answer: An investment that matures in five years

Explanation:

Both investments may be of equal risks, but by virtue of having different maturity dates, they will not be priced the same.

This is because the discount rate (opportunity cost) will discount the maturity value more the longer the investment is such that the present value is lower.

4 year investment

= 1,000 / (1.068)^4

= $768.63

5 year investment

= 1,000 / (1.068)^5

= $719.69

The 5 year investment will have a lower present value and will be charged lower.