1. Suppose we want to buy, at time t0, a USD-denominated default-free discount bond, with maturity at t1and current price B(t0, t1). We can say synthetically using bonds denominated in any other currency, as long as an FX forward exists and the relevant credit risks are the same.

• First, we buy an appropriate number of, say, euro-denominated bonds with the samematurity, default risk, and the priceB(t0, t1)EUR
• This requires buying euros against dollars in the spot market at an exchange rate et0.
• Then, using a forward contract on euro, we sell forward the euros received on December 31, when the bond matures.
• The forward exchange rate is Ft0.
• The final outcome is that we pay USD now and receive a known amount of USD atmaturity.
• This should generate the same cash flows as a USD-denominated bond under no-arbitrage conditions.

Draw the cash flows implied in these operations and the corresponding FX swap. (10 Points)