Questions D, E, F

Question 1.60 marks (split equally between sub-questions) You are given the following information about four bonds traded in the market: Bond Coupon rate Time to maturity (years) Price A B D 10% 10% 8% 7% 99 96 97 97 1 2 3 4 a) Find the spot rates in the given market. State all necessary assumptions b) Estimate the expected spot rate for a two-year investment that will be made in the end of the second year. c) Suppose bond N is currently traded at the market at a price of 95. Bond N has a coupon rate of 8% and 3 years to maturity. Are there any arbitrage opportunities? If yes, provide a detailed strategy to obtain an arbitrage profit. d) Find the yield to maturity of bond N directly and using approximation. What is the intuition behind the approximation formula? Are there any limitations of the approximation formula? e) Company M has issued callable bonds. What is a callable bond? What is the implication of the callability on bond price? Discuss when and why the rights underlying the bond will be exercised, who will exercise the rights? f) Your company is developing a project for which it will need to obtain a one-year $100k loan in one year. The bank has just offered to extend you such a loan and you will be required to pay an 11,5% interest rate on it. You are also provided with the following information about the current market: Current spot rates for 1 and 2 years are 7% and 9% respectively. [Suppose Forward contracts are not traded in the market] Will you accept the bank's offer? Why? Explain your financing strategy