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Arbitrage and Pricing

Student Name

Course Name

Professor Name

University Name

Nov. 22, 2021

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Arbitrage and Pricing

Consider the face value of $100 for the following bonds:

1.

Price = M / (1 + i)n

Here, i = required rate of interest

Price of the 2-year coupon bond

Face∨Maturity Value 100

Po= n
= 2
(1+i) (1+0.46)

100
= =91.398
1.0462

Face∨Maturity Value
2. Yield to Maturity of zero-coupon bond= n
−1
( Price of the bond)

100
YTM𝑧𝑒𝑟𝑜 = 1/ 3
−1 = 3.92%
89.11

3.

Calculate the price with no-arbitrage for the annual-pay coupon bond are as follows:
 
Year 1 Payment = $5
Year 2 Payment = $105
YTM1 = 3.82%
YTM2 = 4.60%
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$5 $ 105
Pcoupon= 1+ 3.82% + 2
=$ 100.78
( 1+ 4.60 %)

4.

a. Because the coupon bond's price is higher than its fair value, it should sell short. The deal

can be structured in a variety of ways. First, it may sell one coupon bond and hedge it by

purchasing 0.05, 1-year zero-coupon bonds, and 1.05 two-year zero-coupon bonds. It results

in an immediate cash flow of $0.22 (101-100.78) and cash flows that balance during the first

and second years.

Instead, it may do the same thing, only invest the $0.22 in 2-year coupon bonds,

making the total position in two-year zero 1.0524 bonds. Its investment yields no immediate

cash flow, balanced payments at time 1, and a profit of $0.24 at time 2.

b.

The profit in dollars is $0.24, as mentioned above. The value of the long side is $101,

and the margin requirement is $20. Therefore, we have the 2-year returns of, respectively,

0.24/101 and 0.24/20.2, which are annualized using the formula for geometric compounding:

P&L ($) P&L in % over two P&L in % annualized

years

Profit relative to long 0.24 0.23% 0.12%

side

Profit relative to 0.24 1.17% 0.58%

margin

5.

Forward Rate: (1 + 𝑦𝑡 𝑇)𝑇−𝑡 = (1 + 𝑦𝑠)−𝑡 (1 + 𝑓𝑡𝑠,𝑇)𝑇-S

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Thus: (1.046)2 = 1.0382 × 𝑓𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒

Forward Rate = 5.39%

6.

The forward rate is higher than our current estimate. Therefore, buy the 2-year zero-coupon

bond and short the one-year bond

Position size: An investment in the 2-year bond leads to the following position in the 1- year

bond

$91.40 / $96.32 = 0.9489 (The 2-year bond is cheaper)

Value of the position after one year:

1-year bond: -0.9489 × $100 = −$94.89

2-year bond: $100 / 1.04 = $96.15

Total Profit of 1.26