Question 3 Consider the following information in Table 2. on three det risk free bonds with annual coupon payments and face value of $1,000 Table 2 Bond A B C Coupon rate (%) Time to maturity tyears) Yield to maturity ("%) 4 1 6.5 2 8 3 (a) Determine the prices of bonds A, B and C (3 marks) (b) Determine the current term structure of spot interest rates and briefly comment on the shape of the term structure (6 marks) (c) Demonstrate how you can use bonds A, B and C to replicate a 3-year zero coupon bond with a face value of $1,000 (6 marks) (d) If the 3-year zero coupon bond in (c) has a market price of $780, show how you can eam an arbitrage profit. Make sure to clearly detail the arbitrage strategy (6 marks) (e) Assume you can buy and sell zero coupon bonds (face value $1,000) of any maturity and that all bonds are trading at their no arbitrage price implied by the term structure calculated in (b). An investor expects to receive a cash inflow of $5 million in one year's time, which she then plans to lend out immediately. The term of the loan will be two years, with fixed coupon interest paid to the investor at the end of each year, along with the repayment of the entire principal amount at the maturity of the loan Explain how the investor could arrange this loan today and lock in the interest rate on the loan, stating exactly how many units of the required bonds need to be long/short and the resultant cash flows. What should the interest rate on this loan be? (8 marks) (1) instead of paying fixed coupons, suppose Bond C pays a floating rate of coupon interest, whereby its coupon rate varies positively with the general level of interest rates. All else being the same, would Bond C's modified duration be higher lower, or the same as its fixed-interest counterpart? Explain your answer you do not need (5 marks) to do any calculations) Page 6 of 8 University of London 2022