Suppose that two risk-free zero-coupon bonds, X and Y, mature in one year. Both bonds have...
Suppose that two risk-free zero-coupon bonds, X and Y, mature in one year. Both bonds have a face value of $200. There are no transaction costs for shorting a bond, but there are for buying the bond. The price of X is $202 and the price of Y is $203.50.
If there are no profitable arbitrage opportunities for an investor, then it must be the case that:
a. The cost of buying a bond exactly equals $1.50 per bond.
b. The cost of buying a bond is less than or equal to $1.50 per bond.
c. The cost of buying a bond is greater than $1.50 per bond.
d. The cost of buying a bond is greater than or equal to $1.50 per bond.
Homework Answers
d. The cost of buying a bond is greater than or equal to $1.50 per bond.
The difference between the two bonds is $1.50. If there is no transaction cost on buying bonds, an arbitrageur would buy bond X and sell bond Y, thus gaining $1.50 risk-free. In order to prevent this arbitrage, the cost of buying should be greater than or equal to $1.50 per bond.
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