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A company has $2m to invest for three months and has the following potential investments available.
Investment Current yield
Short-dated gilts (3 months) 2.56%
Bank bills (1 month) 2.36%
Treasury bills (3 months) 2.34%
Certificates of Deposit (3 months) 2.42%
Interest rates are expected to rise in the next three months by around 1% and the company does not want to make an investment which would be reduced in value by this risk.
Which investment should the company select?
A the gilts
B the bank bills
C the treasury bills
D the certificates of deposit
Answer in the book:: DDoubt:
I am unable to understand this. Sir, please explain this with the help of a suitable example.If an interest-bearing financial instrument is quoted (listed on a stock exchange) then its market value falls as interest rates rise. For example, if current interest rates are 3% and the Government issues Treasury stock of coupon rate (ie the rate printed on the instrument) is 3%, then the market value will be $100 per nominal $100 because if you spend $100 buying 100 nominal you will receive $3 per year (the actual interest received is coupon rate x nominal value) so you will earn at 3% ie the going rate.
If interest rates were to double to 6%, then the market value of 100 nominal would fall to $50 so you would earn at the required rate of $3/$50 = 6%.
So A and C would lose value if interest rates were to rise. B is no good because it is only for 1 month and we want 3.
A CD is little more than a dated deposit. Here, invest $100, earn $2.42 then the $100 principal will be repaid at the end of the three months.
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