The yield to maturity (YTM) on 1-year zero-coupon bonds is 7% and the YTM on 2-y
ID: 2763591 • Letter: T
Question
The yield to maturity (YTM) on 1-year zero-coupon bonds is 7% and the YTM on 2-year zeros is 8%. The yield to maturity on 2-year-maturity coupon bonds with coupon rates of 10% (paid annually) is 7.5%. What arbitrage opportunity is available for an investment banking firm? (Omit the "$" sign in your response.) The arbitrage strategy is to buy zeroes with face value of $ and $ , and respective maturities of one year and two years. What is the profit on the activity? (Do not round intermediate calculations. Round your answer to 2 decimal places. Omit the "$" sign in your response.) Profit $ each bondExplanation / Answer
Solution.
The price of the coupon bond, based on its yield to maturity, is:
100 PA(7.5%, 2) + 1000 PF(7.5%, 2) = $1,271.18.
If the coupons were stripped and sold separately as zeros, then based on the yield to maturity of
zeros with maturities of one and two years, the coupon payments could be sold separately for
[100/1.07] + [1,100/1.08^2] = $1,036.62.
The arbitrage strategy is to buy zeros with face values of $100 and $1,100 and respective maturities of one and two years, and simultaneously sell the coupon bond.
B . The profit equals $2.82 on each bond
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