Tutorial 1 Solutions

Attheendofyear2yougot1dollarasbond2beingmaturein

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

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...
View Full Document

This note was uploaded on 01/28/2013 for the course SEEM 5840 taught by Professor Doctorw during the Fall '12 term at CUHK.

Ask a homework question - tutors are online