Suppose that the 5-year rate is 6%, the 7-year rate is 7% (both expressed with annual compounding), the daily volatility of a 5-year zero-coupon bond is 0.5%, and the daily volatility of a 7-year zero-coupon bond is 0.58%. The correlation between daily returns on the two bonds is 0.6. Map a cash flow of $1,000 received at time 6.5 years into a position in a 5-year bond and a position in a 7-year bond using the approach in the appendix. What cash flows in 5 and 7 years are equivalent to the 6.5-year cash flow?

AppendixLO1