Problem:The market one-year, strip (zero) spot rate is 4.5%, and the forward rate from year one to year two (meaning for lending/borrowing money in a year for one more year) is 3.5%. Today, an individual is willing to lend or borrow money for two years at an annual rate of 4.6%. Is there an arbitrage opportunity? If yes describe it.

Solution: YES, there is an arbitrage opportunity. The strategy is to borrow X for one year at 4.5% and further borrow from year 1 to 2 at 3.5% then lend X for 2 years at 4.6%.

Can anyone please explain the rationale/reasoning for the strategy?