For a particular bond market, the following information is available on risk-free zero coupon bonds redeemable...

 

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For a particular bond market, the following information is available on risk-free zero coupon bonds redeemable at a face value of £100: Maturity Price 1 year £99 2 year £98 3 year £87 Assume perfect capital markets, with no arbitrage opportunities and annual compounding. a) Determine the equilibrium market price of a bond redeemable at a face value of $100 in three years that pays a coupon of 3% annually. [25 marks] b) Assume that the bond studied in a) is trading in the market at a price of £100: what arbitrage opportunities would be available to investors? Devise a trading strategy that would generate a risk-free profit. [20 marks] c) Today we agree that you will lend me £100 at Year 1 to be paid back with interest at Year 2. Derive the arbitrage-free forward rate of the loan, assuming that the loan is risk-free. [25 marks] d) Suppose the Governor of the Bank of England announces that interest rates on short-term UK government bonds will rise over the next 3 years, and the market believes him. What will happen to today's interest rate for 3-year corporate bonds? [30 marks] For a particular bond market, the following information is available on risk-free zero coupon bonds redeemable at a face value of £100: Maturity Price 1 year £99 2 year £98 3 year £87 Assume perfect capital markets, with no arbitrage opportunities and annual compounding. a) Determine the equilibrium market price of a bond redeemable at a face value of $100 in three years that pays a coupon of 3% annually. [25 marks] b) Assume that the bond studied in a) is trading in the market at a price of £100: what arbitrage opportunities would be available to investors? Devise a trading strategy that would generate a risk-free profit. [20 marks] c) Today we agree that you will lend me £100 at Year 1 to be paid back with interest at Year 2. Derive the arbitrage-free forward rate of the loan, assuming that the loan is risk-free. [25 marks] d) Suppose the Governor of the Bank of England announces that interest rates on short-term UK government bonds will rise over the next 3 years, and the market believes him. What will happen to today's interest rate for 3-year corporate bonds? [30 marks]

Answer rating: 100% (QA)

SOLUTION a To determine the equilibrium market price of a bond redeemable at a face value of 100 in three years that pays a coupon of 3 annually we can use the formula for the price of a bond Price Co... View the full answer