C

For simplicity:

6 7/8 bond is BOND A

7 3/4 bond is BOND B

5 1/2 bond is BOND C

* he divides all of his prices by 32 (look at the solutions and youll see)

What I know:

M = 100

the 8/15/94 cash flow is calculated from (5.5% / 2) x 100 = 2.75

the 2/15/95 cash flow is just M + C which is 100 + 2.75 = 2.75

What i need to know:

What is the formula for replicating the portfolio? Basically, can you just explain this in easier terms?

4, (10 points) Consider the following three bonds (settlement: 2/15/94). Coupon Rate Maturity Price 8/15/94 101:20 2/15/95 101:18 2/15/95 103:24 Construct a portfolio of the 67 and the 73 bonds which replicates the cash flows of the 5 bond. Please compare the price of the replicating portfolio to the price of the 5 arbitrage opportunity, please state your trading strategy It is helpful as we begin to list the 8/15/94 and 2/15/95 cash flows of the bond we are replicating bod, If there is an 8/15/94 2.75 2/15/95 02.75 Cash Flow For simplicity. I will rename the bonds as follows: 67 Bond A; 7 Bond B; 5 Bond C I will use to represent the number of units of Bond A in the replicating portfolio and B to represent the number of units of Bond B in the replicating portfolio So we have AX(100 + 100 = 2.75 B 100 + 100 2102.75 Solving them, we have B-0.9892 and A-0.0105. That is, we buy 0.9892 of Bond B, and we sell short 0.0105 of Bond A To see whether there is arbitrage opportunity, we need to calculate the price of the replicating portfolio and compare it with the price of the bond we are replicating 24 32 20 32 Price of Replicating Portfolio = 0.9892 103-_ 0.0 105 101-101.5623 Price of Bond C-101 -101.5625 Since the replicating portfolio is cheaper, we can buy the replicating portfolio and sell short one 32 unit of Bond C. Doing this, we can capture SO.0002 per transaction