Question
Bond prices and the yield curve The table below shows the term structure of the zero-coupon, risk-free, interest rates. ----------------------------------------------------------- Term Zero (years) yield (%)
Bond prices and the yield curve The table below shows the term structure of the zero-coupon, risk-free, interest rates.
----------------------------------------------------------- Term Zero (years) yield (%) ----------------------------------------------------------------- 1 5.50 2 5.70 3 5.85 4 6.40 5 6.95 -----------------------------------------------------------
The table below shows the term, in years, the annual coupon rate and the price of 5 risk-free bonds. All bonds have a face falue F = 1000 and all bonds with a positive coupon rate make one annual coupon payment. ----------------------------------------------------------- Term Coupon Price Bond (years) rate (%) ($) ----------------------------------------------------------------- A 1 0.00 947.87 B 2 3.50 1009.56 C 3 8.00 1108.08 D 4 7.00 1022.90 E 5 6.00 915.52 -----------------------------------------------------------
Are some of these bonds mispriced with respect to the arbitrage-free prices we obtain using the yield curve? An overvalued bond is a bond for which the posted price is at least $5 greater than the price obtained with the yield curve. An undervalued bond is a bond for which the posted price is at least $5 smaller than the price obtained with the yield curve. Otherwise, a bond is considered as correctly priced.
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A.
Bond A is correctly priced, Bond B is overvalued compared to its arbitrage-free price, Bond C is overvalued compared to its arbitrage-free price, Bond D is correctly priced, Bond E is undervalued compared to its arbitrage-free price. -
B.
Bond A is overvalued compared to its arbitrage-free price, Bond B is correctly priced, Bond C is correctly priced, Bond D is overvalued compared to its arbitrage-free price, Bond E is undervalued compared to its arbitrage-free price. -
C.
Bond A is overvalued compared to its arbitrage-free price, Bond B is undervalued compared to its arbitrage-free price, Bond C is undervalued compared to its arbitrage-free price, Bond D is overvalued compared to its arbitrage-free price, Bond E is correctly priced. -
D.
Bond A is undervalued compared to its arbitrage-free price, Bond B is correctly priced, Bond C is correctly priced, Bond D is undervalued compared to its arbitrage-free price, Bond E is overvalued compared to its arbitrage-free price.
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