Question 1 You observe the following information on U.K. default-free government bonds. All bonds pay annual coupons and have a par value of 100. Bond A Bond B Bond C Price 96.266 103.885 Maturity 2 years 2 years 2 years Coupon Rate 2% 6% 10% (a) Using Bond A and Bond B what is the current term structure of interest rates? [8 marks] (b) Explain the current term structure of interest rates from part (a) using term structure theories. [6 marks] (c) How many units of Bond A and Bond B do you need to buy/short to replicate the cash flows of Bond C? What is the price of this replicating portfolio? (8 marks] (d) Without doing any calculations explain which bond will have the highest Macaulay duration and which bond will have the lowest Macaulay duration? [3 marks] (e) If Bond C is actually currently trading at 110 is there an arbitrage opportunity? If so clearly detail the arbitrage strategy and show all resultant cash flows. [8 marks] Question 1 You observe the following information on U.K. default-free government bonds. All bonds pay annual coupons and have a par value of 100. Bond A Bond B Bond C Price 96.266 103.885 Maturity 2 years 2 years 2 years Coupon Rate 2% 6% 10% (a) Using Bond A and Bond B what is the current term structure of interest rates? [8 marks] (b) Explain the current term structure of interest rates from part (a) using term structure theories. [6 marks] (c) How many units of Bond A and Bond B do you need to buy/short to replicate the cash flows of Bond C? What is the price of this replicating portfolio? (8 marks] (d) Without doing any calculations explain which bond will have the highest Macaulay duration and which bond will have the lowest Macaulay duration? [3 marks] (e) If Bond C is actually currently trading at 110 is there an arbitrage opportunity? If so clearly detail the arbitrage strategy and show all resultant cash flows. [8 marks]