QUESTION 3 Suppose under the pure expectations theory, we now have a downward sloping yield curve and the following information: The current yield for 1-year bond is 8% p.a. compounded annually. The market expects that the future 1-year short-term yield (i.e., the forward rate between year 1 and year 2) is 7% p.a. compounded annually. The current yield for 2-year bond is 7.2% p.a. compounded annually. What is your arbitrage strategy?

a. Issue 2-year bond and invest in 1-year bond

b. Issue 2-year bond, invest in 1-year bond and invest in 1-year forward rate

c. Invest in 2-year bond, issue 1-year bond and sell at 1-year forward rate

d. There is no arbitrage opportunity.