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) he thinks rates will rise in the future and locking in long-term rates today may provide the highest long-run average return.
Answer: A
Explanation: A) Locking in low long-term rates today may be a successful strategy if long-term rates become even lower in the future. If rates are expected to rise in the future, then locking in the lower long-term rates now will result in a LOWER long-run average, which is NOT a rational decision.
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