Question: Consider a forward starting 2-year fixed for floating interest rate swap where the floating rate is rt-1,1 , and the cash flows are exchanged at

Consider a forward starting 2-year fixed for floating interest rate swap where the floating rate is rt-1,1 , and the cash flows are exchanged at t = 9 and 10.

Given:

- Forward contract A matures at t = 8. The underlying is zero coupon bond A, which matures at t = 9, and has a face value of $10,000. Forward price = $9000.

- Forward contract B matures at t = 8. The underlying is zero coupon bond B, which matures at t = 10, and has a face value of $10,000. Forward price = $8500.

a) What is the fair swap rate on the forward swap?

b) Suppose the traded swap rate was 0.1% higher than your answer to part a. Describe how you would construct an arbitrage. At t = 0 you can enter into the swap contract for $100 notional, and also trade the two forward contracts. You can also trade 1-year zero coupons at any point in time. Construct the arbitrage in such a way that the arbitrage profits are realized at t = 9 and 10 and are each equal. Your answer must describe exactly all the transactions you implement and at what point in time.

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