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Q3. (20 points) Structure of interest rate Assume that you would like to invest a certain amount of money for two years and considers investing in a one-year bond that pays 6 percent and a two-year bond that pays 7 percent. You are considering the following investment strategies: Strategy A: In the first year, buy a one-year bond that pays 6 percent. Once that bond matures, buy another one-year bond that pays the forward rate. Strategy B: In the first year, buy a two-year bond that pays 7 percent annually. i. If the one-year bond purchased in year two pays 5 percent, which strategy should you choose? Briefly explain the rationale of your choice. ii. Calculate the one-year forward rate one year from now that would make you indifferent between Strategy 1 and Strategy 2. iii. Now assume that you take liquidity premium into consideration. If the oneyear bond purchased in year two pays 11 percent, and the liquidity premium on a two-year bond is 0.7 percent. Which strategy should you choose? Briefly explain your answer. iv. Calculate the one-year forward rate one year from now that would make you indifferent between Strategy 1 and Strategy 2, this time, your calculation should take liquidity premium for the two-year bond into consideration. v. Assume that you now consider investing for a three-year horizon. As of today, a three-year bond pays 10 percent annually, a two-year bond pays 9 percent annually. Use this information, estimate the one-year forward rate two years from now

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