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Suppose that in the fixed-income securities market, the current one-year and two-year spot interest rates are 4.000% and 5.500%, respectively. (That is, RMrkt 40,1 =
Suppose that in the fixed-income securities market, the current one-year and two-year spot interest rates are 4.000% and 5.500%, respectively. (That is, RMrkt 40,1 = 4.000% and Mrkto,2 = 5.500%.) In addition, in the market, the current one-year forward rate one year from now [FO, Mrkt , 1] is 6.000%. 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 1 (t=1) are equal to zero. However, they have a maximum-possible positive net cash flow at the end of Year 2 (t=2). What is the amount of that maximum positive net cash flow at the end of Year 2 (t = 2)? (Please make sure that, we are putting a constraint of borrowing/lending amount of exactly $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 a limitation of the machine grading. Thank you!) (Round off your final answer to four decimal places. For the intermittent steps, round off to at least six decimal places, so that your answer is as close as possible to the correct answer.)
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