Assume the following yield curve for zero-coupon bonds with a face value of 100:

Maturity YTM

1 Year 7%

2 Years 8%

3 Years 8%

4 Years 7%

5 Years 6%

Given the following

A. The yield on a five-year, risk-free Treasury-note = 5%

B. The yield on a five-year, BB-quality bond = 8%, with 3% spread reflecting only credit risk.

C. The credit spread on a five-year CDS on the 5-year, BB-quality bond of 2%.

1. Explain how a bond a bond investor looking for a 5-year, risk-free investment could gain a 1% yield over the risk-free investment by using a CDS.

2. Explain what an arbitrageur would do.

3. Comment on the impact the actions by investors and arbitratgeurs would have on determining the equilibrium spread on a CDS.