James is a rational investor wishing to maximize his return over a 20-year period. The current yield curve is inverted with one-year rates at 5.00% and 20-year rates at 3.50%. James will invest in the lower-rate 20-year bonds if:
A) he thinks rates will fall in the future and locking in long-term rates today may provide the highest long-run average return.
B) he thinks rates will rise in the future and locking in long-term rates today may provide the lowest long-run average return.
C) he thinks rates will remain flat at 5% in the future and locking in long-term rates today will prevent him from appearing greedy to those without this investment opportunity.
D) James has no idea what to do and should just skip this question.

Question

Quizplus · Accepted Answer

James should invest in the lower-rate 20-year bonds if he thinks rates will fall in the future and locking in long-term rates today may provide the highest long-run average return. This is because, in an inverted yield curve, long-term rates are expected to decrease in the future. By investing in the lower-rate 20-year bonds now, James can lock in the current lower rate and potentially benefit from the future decrease in rates, resulting in a higher return over the 20-year period.

James Is a Rational Investor Wishing to Maximize His Return