Question 2. Suppose the current ZCB prices for maturity in two years and in five years are 0.8 and 0.7, respectively. Suppose the two-year forward three-year libor rate is 4%. Determine if there is an arbitrage opportunity. If so, find an arbitrage portfolio. Make sure that you verify the portfolio is an arbitrage portfolio.Hint: In your arbitrage portfolio you will need to include a forward rate agreement.

Question
Asked Oct 19, 2019
47 views

Question 2. Suppose the current ZCB prices for maturity in two years and in five years are 0.8 and 0.7, respectively. Suppose the two-year forward three-year libor rate is 4%. Determine if there is an arbitrage opportunity. If so, find an arbitrage portfolio. Make sure that you verify the portfolio is an arbitrage portfolio.

Hint: In your arbitrage portfolio you will need to include a forward rate agreement.

check_circle

Expert Answer

Step 1

If Pn is the price of ZCB with maturity of n years and Sn is the spot rate for year n then,

Pn = (1 + Sn)-n

Hence, (Pn)-1/n = (1 + Sn)

Hence, Sn = (Pn)-1/n - 1

Step 2

Hence,

S2 = (P2)-1/2 – 1 = 0.8-1/2 – 1 = 11.80%

S5 = (P5)-1/5 – 1 = 0.7-1/5 – 1 = 7.39%

Step 3

two-year forward three-year libor rate = 2F3 = 4%

Hence, no arbitrage five year spot rate, S should follow the following equation:

(1 + S)5 = (1 + S2)2  x (1 + 2F3)3 = (1 + 11.80%)2 x (1 + 4%)3 = 1.40608

Hence, ...

Want to see the full answer?

See Solution

Check out a sample Q&A here.

Want to see this answer and more?

Solutions are written by subject experts who are available 24/7. Questions are typically answered within 1 hour.*

See Solution
*Response times may vary by subject and question.
Tagged in

Business

Finance

Related Finance Q&A

Find answers to questions asked by student like you
Show more Q&A
add
question_answer

Q: If you have a $125,000 mortgage with a $700.00 monthly payment, payable over 30 years, what interest...

A: Calculation of Interest Rate:The interest rate is 5.38%.Excel Spreadsheet:

question_answer

Q: Assume that you manage a risky portfolio with an expected return of18% and a standard deviation of 2...

A: a.The expected return of portfolio can be computed by the following equation:

question_answer

Q: The number of Internet users in Mexico between 2004 and 2008 can be modeled as u(t) 8.02(1.17) milli...

A: Part (a)Average rate of change of the function u(t) over the interval (a, b) will be as given on the...

question_answer

Q: You found the following stock quote for DRK Enterprises, Inc., at your favorite website. You also fo...

A: Dividend yield refers to the annual dividend return based on the last traded price of share.

question_answer

Q: I attached an image of things that "could go onto a cash flow statement" would you advise using any ...

A: The building of a factory or purchase of equipment will be counted while calculating capital budgeti...

question_answer

Q: You have maxed out your $10,000 credit card, which is being charged 12.8% annual interest compounded...

A: Calculation of minimum monthly and weekly payments:Answer:The minimum monthly payment and weekly pay...

question_answer

Q: Assume that you manage a risky portfolio with an expected rate of return of 14% and a standard devia...

A: a.Calculation of Proportion y:The Proportion y is 87.50%.

question_answer

Q: How would I calculate this using excel? or a financial calculator?   the common stock of clinton kne...

A: It is given that,Current price of stock is $20.Increasing rate is 3%.Decreasing rate is 3%.

question_answer

Q: Please show all equations and work as needed. Make the correct answer clear. If possible, please typ...

A: Free cash flow is a perpetuity C = $ 10 mn growing at g = 5%;Tax rate = T = 25%;Cost of debt, Kd = 6...