Arbitrage with Bonds1

It is February 15, 2020. Three bonds, as listed in Table 1 below, are for sale. Each
bond has a face value of $100. Every 6 months, starting 6 months from the
current date and ending at the expiration date, each bond pays
0.5 * (coupon rate) * (Face value).
At the expiration date the face value is paid. For example, the second bond pays
 $2.75 on 8/15/20
 $102.75 on 2/15/21

Bond Current Price Expiration Date Coupon Rate

1 $10l.625 8/15/2020 6.875
2 $10l.5625 2/15/2021 5.5
3 $103.80 2/15/2021 7.75
Table 1: Bond Data

Given the current price structure, the question is whether there is a way to make
an infinite amount of money. To answer this, we look for an arbitrage. An
arbitrage exists if there is a combination of bond sales and purchases today that
yields
 a positive cash flow today
 nonnegative cash flows at all future dates
If such a strategy exists, then it is possible to make an infinite amount of money.
For example, if buying 10 units of bond 1 today and selling 5 units of bond 2
today yielded, say, $1 today and nothing at all future dates, then we could make
$k by purchasing 10k units of bond 1 today and selling 5k units of bond 2 today.
We would also be able to cover all payments at future dates from money
received on those dates. Clearly, we expect that bond prices at any point in time
will be set so that no arbitrage opportunities exist.

1
Based on 4-104 (p. 206) in Practical Management Science (4th ed., Winston and Albright, 2012
Duxbury Press).
(a) Show that an arbitrage opportunity exists for the bonds in Table 1. (Hint: Set
up an LP that maximizes today's cash flow subject to constraints that cash
flow at each future date is nonnegative. You should get a "no convergence"
message from Solver.)
(b) Usually bonds are bought at an ask price and sold at a bid price. Consider the
same three bonds listed in Table 1 and suppose the ask and bid pr ices are
as listed in Table 2. Show that these bond prices admit no arbitrage
opportunities.
Bond Ask Price Bid Price
1 $10l.6563 $l0l.5938
2 $10l.5938 $101 5313
3 $103.7813 $103.7188
Table 2: Bid and Ask Prices