1. Suppose that the prevailing Treasury spot rate curve is the one shown below in Exhibit 5.

a. What is the value of a 5% 4-year Treasury issue?

b. Suppose that the 5% 4-year Treasury issue is priced in the market based on the on-the-run Treasury yield curve. Assume further that the yield on a 5% 4-year Treasury issue is 5.15%, so that each cash flow is discounted at 5.15% divided by 2. What is the price of the 5% 4-year Treasury issue based on a 5.15%discount rate?

c. Given the arbitrage-free value found in part a and the price in part b, what action would a dealer take and what would the arbitrage profit be if the market priced the 5% 4-year Treasury issue at the price found in part b?

d. What process assures that the market price will not differ materially from the arbitrage-free value?

EXHIBIT5 Determination of the Arbitrage-Free Value ofan 8% 10-year Treasury Perioc Cash How (s) Spor rare Present value ($) ears 0.5 1.0 1.5 2,0 2.5 3.0 3.000O 3.3000 3.5053 3.9164 4.4376 4.752o 4.9622 5.0650 .1701 5.2772 5.3864 5.4976 .6108 5.6643 5.719 5.7755 5.8331 5.9584 6.0863 6.2169 3.9409 3.8712 5.7968 3.7014 3.5843 3.4743 3.3694 3.2747 3.1791 3.0829 2.9861 2.8889 2 3 4 4 5 6 7 4.0 4.5 io 5.5 6.0 6.5 7.0 12 13 14 15 1G 17 18 19 20 2.791 2.7055 2.6205 2.536S 2.4536 2.3581 2.2631 56.3830 113.2621 8.0 8.5 9.0 10.0 104 Ora The spot rate s an annual discount rate. The conventiobtain a semiannual iscount rate is to take one-half the annual disco unt rate. So, for period 6 (i.e., 3 yea rs), the spoc rate is 4.7320)(. The semiannual discount rate is 2.376%. The present value for the cash low is equal to: Spor rate/2)Pe EXHIBIT5 Determination of the Arbitrage-Free Value ofan 8% 10-year Treasury Perioc Cash How (s) Spor rare Present value ($) ears 0.5 1.0 1.5 2,0 2.5 3.0 3.000O 3.3000 3.5053 3.9164 4.4376 4.752o 4.9622 5.0650 .1701 5.2772 5.3864 5.4976 .6108 5.6643 5.719 5.7755 5.8331 5.9584 6.0863 6.2169 3.9409 3.8712 5.7968 3.7014 3.5843 3.4743 3.3694 3.2747 3.1791 3.0829 2.9861 2.8889 2 3 4 4 5 6 7 4.0 4.5 io 5.5 6.0 6.5 7.0 12 13 14 15 1G 17 18 19 20 2.791 2.7055 2.6205 2.536S 2.4536 2.3581 2.2631 56.3830 113.2621 8.0 8.5 9.0 10.0 104 Ora The spot rate s an annual discount rate. The conventiobtain a semiannual iscount rate is to take one-half the annual disco unt rate. So, for period 6 (i.e., 3 yea rs), the spoc rate is 4.7320)(. The semiannual discount rate is 2.376%. The present value for the cash low is equal to: Spor rate/2)Pe