Question

The yield to maturity (YTM) on 1-year zero-coupon bonds is 5% and the YTM on 2-year zeros is 6%. The yield to maturity on 2-year-maturity coupon bonds with coupon rates of 10% (paid annually) is 5.7%. a. What arbitrage opportunity is available for an investment banking firm? The arbitrage strategy is to buy zeros with face values of $ and $ , and respective maturities of one year and two years.

Answer 1

Answer:

a. What arbitrage opportunity is available for an investment banking firm?

The arbitrage strategy is to buy zeros with face values of $100 and $1,100, and respective maturities of one year and two years.

This would generate a risk free profit = $4.83

Explanation:

the price of a 2 year bond with annual coupons = PV of maturity value + PV of coupons

($100 / 1.057) + ($1,100 / 1.057²) = $94.61 + $984.56 = $1,079.07

price of a 2 year coupon bond using YTM of zero coupon bonds:

($100 / 1.05) + ($1,100 / 1.06²) = $95.24 + $979 = $1,074.24

risk free profit = $1,079.07 - $1,074.24 = $4.83