Given 1-year, 2-year, 3-year par rates (or yield-to-maturity) of an institution's bonds are 2%, 3%, 4%:

(a) Find the 1-year, 2-year, 3-year spot rates. Use these spot rates to price a fixed rate 3-year 5% coupon bond issued by the same institution.

(b) Suppose interest rate volatility is incorrectly perceived by the market as 15% p.a. when it should be 20% p.a., can you make arbitrage profits by trading in these institution's bonds?

(c) Suppose on top of the information you also know that next year's 1-year spot rate will likely be below 4%, can you make arbitrage profits? How?

Answer rating: 100% (QA)

a To find the spot rates we can use the formula 1 Spot Raten 1 Par Raten where n is the number of ye... View the full answer