The yield on a default-free four-year zero-coupon bond is 3%; the yield on a

default-free five-year zero-coupon bond is 4.5%. The bonds have a face value
of $1000 and are traded in an open market. You are a money manager and
know that you will have a net inflow of $100,000 four years from now, and an
obligation (i.e. a net outflow) of $100,000 one year later (i.e. five years from
now). Once you get your inflow, you plan to invest part of this inflow (as much
as necessary) in risk-free bonds for a year, and immediately pay the rest to
your investors in the form of a profit. You would like to hedge the interest-rate
risk that is involved in this future bond investment, in order to be able to pre-
announce your expected profit today, but also ensure that your obligation is
covered.

(a) Based on today’s yields, what is the no-arbitrage yield of a one-year

forward-rate agreement starting four years from now?

(b) Assuming you can obtain such a forward-rate agreement, how much of
your inflow will you need to re-invest, and how much will you be able to pay
to investors?

(c) Now assume that no such forward-rate agreements are being offered in
the market. How can you construct one yourself (i.e. replicate one), in order to
hedge your interest-rate risk? Carefully describe your strategy, and show that
the resulting cash flows mirror those of the forward-rate agreement you are
trying to create. Assume you can go either long or short in either bond, and
you can also buy or sell fractions of bonds.

Price of $1000 4-year zero coupon bond at 3% yield = $1000/ (1+3%) ^4 = $888.48705

Price of $1000 5-year zero coupon bond at 4.5% yield = $1000/ (1+4.5%) ^5 = $802.45105