Question
Katrina Black, portfolio manager at Coral Bond Management, Ltd., is conducting a training session with Alex Sun, a junior analyst in the fixed income department.
Katrina Black, portfolio manager at Coral Bond Management, Ltd., is conducting a training session with Alex Sun, a junior analyst in the fixed income department. Black wants to explain to Sun the arbitrage- free valuation framework used by the firm. Black presents Sun with Exhibit 1, showing a fictitious bond being traded on three exchanges, and asks Sun to identify the arbitrage opportunity of the bond. Sun agrees to ignore transaction costs in his analysis. Exhibit 1 Three- Year, 100 par, 3.00% Coupon, Annual Pay Option- Free Bond Eurex NYSE Euronext Frankfurt Price 103.7956 103.7815 103.7565 Black shows Sun some exhibits that were part of a recent presentation. Exhibit 3 presents most of the data of a binomial lognormal interest rate tree fit to the yield curve shown in Exhibit 2. Exhibit 4 presents most of the data of the implied values for a four- year, option- free, annual pay bond with a 2.5% coupon based on the information in Exhibit 3. Exhibit 2 Yield to Maturity Par Rates for One-, Two-, and Three- Year Annual Pay Option- Free Bonds One- year Two- year Three- year 1.25% 1.50% 1.70%
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