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Treasury bond ( Notes ) which was issued eight years ago in a low interest environment. Bond B is a three - year Treasury bond
Treasury bond Notes which was issued eight years ago in a low interest environment. Bond
B is a threeyear Treasury bond Notes issued one year ago in a high interest environment.
The two bonds have two years left to maturity each and the following coupon payments, face
value and prices.
t t Price at t
Bond A: $ $$ $
Bond B: $ $$ $
a Is there an arbitrage? p
b If yes, find one arbitrage portfolio and determine the price and payoff of that portfolio.
p
c The hedge fund manager understands arbitrage trading and asks the sales and trading
team of an investment bank to execute a trade of the two bonds such that he makes
$ million at t and $ at t as well as obtains some money at t How does this
trade look like? p
d When executing this arbitrage trade, the hedge fund buys bond B What is the
intuition? It is useful to compare the yields of the two Treasury bonds. p
e As arbitrageurs are buying bond B the price of bond B increases to Given
pA$ and pB$ is there still an arbitrage? p
f Given pA$ and pB$ what is the oneyear yield of a Treasury bond in this
market?
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