Part B Answers for S1, S2, S3: Borrow, Lend, or Do Nothing

Problem#1 Part A: Suppose that in the fixed-income securities market, the two-year and three-year spot interest rates are 8.500% and 10.000%, respectively. [That is, RMrkt.,2 8.500% and *0,3 = 10.000%.] = R Mrkt Then, as per the no-arbitrage principle, what is the current one-year forward rate two years from now? That is what is the (theoretical) value of F0, Theo 2,1 ? [Type your answer in numerical format, not in percentages. For example, if your answer is 1.234%, then type as 0.01234. You will not earn any credit if you type as 1.234 or 0.1234.] Problem 1 Part B: (This is in continuation to the earlier question (problem 1 part A). Suppose that in the fixed-income securities market, the two-year and three-year spot interest rates are 8.500% and 10.000%, respectively. (That is, RMrkt, 8.500% and RMrkt = 10.000%.) = 0,2 0,3 In addition, in the market, the current one-year forward rate two-years from now (F0,Mrkt2,1) is 12.000%. What should be an arbitrager's strategy at t = 0 ? (Borrowing is equivalent to taking a loan; whereas, Lending is equivalent to investing / depositing your savings.) S1) Enter into a forward rate agreement, whereby, they will [ Select ] at one-year forward rate two-years from now. S2) They will [Select ] at two-year spot rate. S3) They will [Select ] at three-year spot rate. Problem#1 Part C: (This is in continuation with earlier two questions.) Suppose that in the fixed-income securities market, the two-year and three-year spot interest rates are 8.500% and 10.000%, respectively. (That is, RMrkt, 8.500% and *0,3 = 10.000%.) - 0,2 RMrkt = In addition, in the market, the current one-year forward rate two-years from now (FO, Mrkt2,1) is 12.000%. Assume that an arbitrager can borrow or lend exactly $1,000 in the forward interest rate market. They execute an arbitrage strategy such that their net cash flows at time t=0 (now) and at the end of Year 2 (t=2) are equal to zero. However, they have a maximum-possible positive net cash flow at the end of Year 3 (t=3). What is the amount of that maximum positive net cash flow at the end of Year 3 (t = 3)? = (Please make sure that, we are putting a constraint of $1,000 for the forward interest rate transaction. It is mainly to have the same correct answer for each of us. This is to accommodate limitation of the machine grading. Thank you!) (Round off your final answer to four decimal places.)