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The current zero-coupon interest rates for terms 4 and 5 years are 7.4% and 7.5% per annum respectively. Meredith wishes to invest today and has an investment horizon of 4 years. Specifically, her target is to have $100,000 in 4 years time. She is conside ring two investment strategies: (i) buying the 4 year bond and (ii) investing the amount calculated for the first strategy but instead buying the 5-year bond and selling the bond after 4 years have passed.
Required:
a) How much will Meredith need to invest today if she implements strategy (i)?
b) Suppose Meredith decides to implement strategy (ii). What 1 -year interest rate in the fourth year, will see Meredith exceed her target?
c) How would the proponents of the expectations hypothesis interpret this result? How would proponents of the liquidity premium hypothesis interpret this result?
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