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