The yield to maturity (YTM) on 1-year zero-coupon bonds is 5% and the YTM on 2-year...
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 rate of 12% (paid
annually) is 5.8%. What arbitrage opportunity is available for an
investment banking firm? What is the profit on the activity?
Homework Answers
Answer:
A]
The price of the coupon
bond, based on its YTM, is:
Using Calculator,
N = 2, I/Y = 5.8, PMT = -120, FV = -1000 and Compute PV = $1113.99
If the coupons were stripped and sold separately as
zero-coupon bonds, then based on the YTM of zero-coupon bonds with
maturities of one and two years, the coupon payments could be sold
separately for
[120/1.05] + [1,120/(1.06)2] = $1,111.08.
B]
The arbitrage strategy is
to:
Buy zero-coupon bonds with face values of $120 and $1,120 and
respective maturities of 1 and 2 years
Simultaneously sell the coupon bond.
The profit equals $2.91 on each bond.
Add Answer to:
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