A bond promises a risk-free payment of $1000 in one year. The risk-free rate of interest is 2.64%.
a) What is the price of the bond?
b) If the price of the bond is actually $960, what is the arbitrage strategy? Illustrate all cash flows
today and one year from today.
c) If the price of the bond is actually $990, what is the arbitrage strategy? Illustrate all cash flows today
and one year from today.
Hint: you are able to borrow money from the bank, or deposit money into the bank, at the risk-free
rate of interest. After one year you will pay back your loan plus interest, or receive your savings plus
interest.