Tutorial 1 Solutions

# Attheendofyear2yougot1dollarasbond2beingmaturein

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Unformatted text preview: to lend you money at an interest rate of 6% for the first year and 6.8% in the second year. Show how buying the 2‐year coupon bond with money borrowed from this bank would earn you an arbitrage profit. Answer: Borrow 0.881659 dollar from the bank and buy 1 share of bond 2, initially you cost nothing. At the end of year 2, you got 1 dollar as bond 2 being mature, in the mean time, you should return the bank 0.881659*1.06*1.068=0.9981, and you gain 1‐0.9981=0.0019 c) Now suppose the market quotes an interest rate of 7.2% between year 1 and year 2. Show that borrowing the 2 year zero‐coupon bond and lending at the 1‐year rate and lending at the 1‐year rate and implied forward rate of 7.2% would earn you an arbitrage profit. Answer: Let us follow the suggestion of the problem and sell the 2-year zerocoupon bond. We will create a synthetic borrowing opportunity at the zerocoupon implied forward rate of 7.00238% and we will lend at 7.2%, thus creating an arbitrage opportunity. In particular, we will h...
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## This note was uploaded on 01/28/2013 for the course SEEM 5840 taught by Professor Doctorw during the Fall '12 term at CUHK.

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