Problem A.

Construct a Replicating Portfolio (RP) to replicate a 1.5-year

Bond-0 that pays A1 percent of coupon per year. The available bonds for

replication are: a one year zero coupon Bond-1, a 1.5-year Bond-2 that pays

A2 percent coupon per year, and a 1-year Bond-3 which pays A3 percent

coupon per year. All the bonds (Bond-0, Bond-1, Bond-2, and Bond-3) have

the same face value of $100 and pay their annual coupons two times a year.

Compute an arbitrage trading strategy to generate profits, if any, when the

current market prices of the four bonds, respectively, are A4, A5, A6 and

A7.

1. What is the dollar face value of Bond-1 in the RP?

2. What is the dollar face value of Bond-2 in the RP?

3. What is the dollar face value of Bond-3 in the RP?

4. What is the cost of the RP? 5. What is the arbitrage fair price of Bond-0?

6. Write 1 if Bond-0 is to be held long and 0 if Bond-0 is to be held short

in arbitrage trading strategy.

7. Write 1 if Bond-1 is to be held long and 0 if Bond-1 is to be held short

in an arbitrage trading strategy.

8. Write 1 if Bond-2 is to be held long and 0 if Bond-2 is to be held short

in an arbitrage trading strategy.

9. Write 1 if Bond-3 is to be held long and 0 if Bond-3 is to be held short

in an arbitrage trading strategy.

uin A1 669116578 A2 9.6 A3 7.6 A4 11.6 A5 103.6 A6 96.2 A7 100.9 B1 106.32 B2 96.84 C1 95.84 C2 3.6 C3 101.16 C4 9.6 D1 107.2 D2 11.6 D3 14.6 D4 9.6 D5 103 D6 107 107