Consider two 5-year bonds: one just issued at par (on the run), yielding 3%, and another, issued a few years ago (off the run) but now having five years to maturity, annual coupons of 3% and yielding 3.2%. a. Assuming annual coupons, discrete compounding, and $100 face value per bond, show that an on the run/off the run arbitrage (long-short trade using $100,000,000 market value of each bond) has very little interest rate risk using an increase in yields of 20bp. (15 points) b. How does your arbitrage perform if rates rise 20bp but the spread narrows to zero (i.e., Yield ON=3.40% and Yield OFF=3.40%. Which was more important: the change in interest rates or the change in the spread? Why? (15 points) Consider two 5-year bonds: one just issued at par (on the run), yielding 3%, and another, issued a few years ago (off the run) but now having five years to maturity, annual coupons of 3% and yielding 3.2%. a. Assuming annual coupons, discrete compounding, and $100 face value per bond, show that an on the run/off the run arbitrage (long-short trade using $100,000,000 market value of each bond) has very little interest rate risk using an increase in yields of 20bp. (15 points) b. How does your arbitrage perform if rates rise 20bp but the spread narrows to zero (i.e., Yield ON=3.40% and Yield OFF=3.40%. Which was more important: the change in interest rates or the change in the spread? Why? (15 points)