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Assume that transaction costs are zero and there is no credit risk in any transaction. Suppose that: (1) the price at time 0 of a

  1. Assume that transaction costs are zero and there is no credit risk in any transaction. Suppose that: (1) the price at time 0 of a 2-year annual-pay coupon bond with face value $100 and a coupon rate of 5% is $88, and (2) the price at time 0 of a 1-year zero coupon bond with face value $100 is $88. What must be the time 0 price of a bond with the following (somewhat unusual) risk-free cash flows?

Year 1 Year 2

Cash flows $60 $ 210

Explain your reasoning in detail. (Hint: use no-arbitrage reasoning.)

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