Question

Question 33 - 36: A bank offers you the following interest rates on three different GICs: (i) a 2 year term with 1% per year and interest reinvested; (ii) a one year term at 0.9% interest; (iii) 2.15% after 2 years. Suppose you expect the one year risk free interest rate in a year from now to be 1.25%. Which investment gives you the highest expected return over two years?

Answer 1

Option i) a 2 year term with 1% per year and interest reinvested- this investment will give the highest return over 2 years.

Suppose the principal amount = $100

Interest in year 1= 100 *1% = $ 1

Interest in year 2 = 101 * 1% = $1.01

Note: 101 is the principal amount in year 2 as the interest from Year 1 is reinvested.

Total interest= 1 + 1.01 = $2.01

Principal amount + interest amount after year 2 becomes= 100 + 2.01 = $102.01

Therefore, this investment will give the highest return over 2 years.