Final answer:
The 2-year zero coupon bond is riskier for investment due to the greater uncertainty over a longer period, as it is exposed to potential changes in market interest rates and inflation risks.
Step-by-step explanation:
When considering which bond to invest in, a 1-year zero coupon bond priced at $0.99 or a 2-year zero coupon bond priced at $0.95, it is important to consider the risk of the bond. Generally, longer-term bonds carry more risk due to the uncertainty over a longer period, such as potential changes in market interest rates. Assessing the risk involves understanding how changes in interest rates can affect a bond's price and attractiveness to investors.
Using the supplied example, let's assume a bond carries no risk. It would be issued at $1,000 and pay $80 per year until its maturity. If interest rates rise to 12%, the value of the bond would decrease as you could invest $964 in an alternative investment at the new rate and receive $1,080 in a year. The bond's price is inversely related to the interest rates; as rates go up, bond prices go down.
Therefore, the 2-year zero coupon bond at $0.95 is riskier for your investment, since it is exposed to the uncertainty of interest rate movements and inflation risks over a longer period than the 1-year bond.