Figure 2.3 (above) shows that the term structure of interest rates can be declining, with short-term spot
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Figure 2.3 (above) shows that the term structure of interest rates can be declining, with short-term spot rates higher than long-term spot rates. How steep can the decline in spot rates be? Consider two STRIPS: One has 3-years to maturity and yields a continuously compounded rate r(0, 3) = 10%, while the second has 5 years to maturity and yields a continuously compounded rate r(0, 5) = 5%. Discuss whether this scenario is possible, and, if not, what arbitrage strategy could be set up to gain from the mispricing.
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