Question

If the price of the 1-year coupon bond was $1030. How would you take advantage of the arbitrage opportunity?

A. Buy 1 unit of 1-yr coupon bond, sell 10 unit of the 6-mo zero and 110 unit of the 1-yr zero

B. Buy 1 unit of 1-yr coupon bond, sell 1 unit of the 6-mo zero and 11 unit of the 1-yr zero

C. Sell 1 unit of 1-yr coupon bond, buy 10 unit of the 6-mo zero and 110 unit of the 1-yr zero

D. Both A and B are correct

Answer 1

The correct answer is option B. Buy 1 unit of 1-yr coupon bond, sell 1 unit of the 6-mo zero and 11 unit of the 1-yr zero

It should not take us long to derive that we are talking about annual coupon rate of 20% and zero bonds with face value of $ 100.

1 year coupon bond cash flows:

• In 6 months time: coupon = 20%/2 x 1,000 = $ 100 - this can be matched by selling 1 unit of 6 month zero
• In 1 years'time: coupon = 20%/2 x 1,000 = $ 100; principal redemption = 1,000; total 1,100; this can be matched by 11 units of 1 yero zero

hence, the correct answer is the option B)