One of the things I loved during all the years I spent training people to be stockbrokers is that you always had to be ready to answer to the unexpected. You could walk into the classroom fully prepared to talk about the analysis of fixed income securities with embedded options, for example, and yet, just before class starts or during one of the breaks, a student would have ‘just one little question’ about taxation, or mining, or economics, or anything else not remotely related to the day’s topic at hand.
The challenge, then, was to be ready at all times to answer all questions on any subject, and to be able to answer it in a basic way, an advanced way, or an academic way as the situation called for. And as much as the students enjoyed trying to play ‘get the teacher’ the teacher enjoyed not getting stumped.
There is, of course, always the exception. Once in a while, there would be a question come up that the teacher just couldn’t answer, knew he couldn’t answer it, and promptly said so.
It happened again last week.
A nice lady named CL wrote in to say “I've read your two articles 'TFSAs should hold cash' (and 'TFSAs should hold cash II') on the Canadian Business Online website, and I have a question about holding GICs.  I am planning to put some money in GICs, but I don't know how long I should lock it in for.  If I lock in for a longer term, I'm afraid that when the economy starts to recover and the rates start to go up, I'll be stuck in a lower return GIC.  In your view, what would be the optimal term such that when it matures, I can renew it at a potentially better rate then?”
And my answer? Sorry, CL, I don’t know.
Let me explain using a simple scenario with just two terms. Let’s say that one-year GICs right now pay 1% per year, that three-year GICs pay 3% per year, that CL has a three-year time horizon, and that she has $1 million to invest (hey, in examples, money is free, so we might as well use big numbers). What are her choices?
Choice One: She can simply buy a three-year GIC that pays 3% per year. If she does this, in three years she will have $1,092,707. She can prove this by multiplying $1,000,000 X (1.03)3 = $1,092,727.
Choice Two: She can buy a one-year GIC paying 1% for the first year. The problem with this choice is that she has no idea what rate she will earn in the second and third years.
However, we can figure out what it needs to be to make her indifferent between buying a one-year GIC now and rolling over in a year, versus buying a three-year GIC now and just holding it. In other words, we can figure out what a two-year GIC needs to be yielding one year from now such that she’s no better off one way or the other.
The math isn’t all that difficult. After one year in the one-year GIC she will have $1,010,000. Therefore, in the ensuing two years she will need to earn an additional $82,727 to make her equal to what a three-year GIC would have paid her. That’s equivalent to a two-year rate, one year from now, of 3.53775%. So in this example, if CL feels two-year rates a year from now will be higher than 3.54%, she should go with the one-year GIC right now. If she thinks they won’t be that high, she should go with the three-year GIC.
Using today’s actual numbers, the best available one-year GIC rate in Canada right now is about 2.07%. The best three-year GIC rate in Canada right now is 3.10%. That implies a two-year rate one year forward of 2.02%.
What do you think, CL? Will the two-year GIC rate be higher than 2.02% a year from now? Me, I don’t have a clue. But, seriously, thanks for asking. It’s been fun thinking about how to answer your query. Now, who else has a question?

By David West