Suppose that you observe the following four bonds trading in the market.

Bond Coupon Time-to-maturity Price

A 5% 0.5 101.99

B 3% 1 101.49

C 4% 1.5 102.96

D 6% 2 108.99

Coupons are paid semi-annually.

1. Calculate zero-coupon yields for maturities of 0.5, 1, 1.5, and 2-years.

2. Calculate the discount factors that the zero-coupon yields imply. Do you see any

potential problems? Why?

3. Suppose that you have a technology that allows you to store money for free (a "mat-

tress") between years 1.5 and 2. That is, if you put $x under your mattress at t = 1.5,

you will still have $x at t = 2. Construct a long-short trading strategy using the four

bonds that earns you free money today.

Hint: Identify which bond you view as overpriced and start by shorting that bond. Then,

use the other bonds to net out the cash flows.