Question

The one year spot rate is currently six percent (6%); the one year spot rate one year from now will be seven percent (7%); and the one year spot rate two years from now will be eight percent (8%). Under the UEH what must today's three year spot rate be? Suppose the three year spot rate is actually nine percent (9%), how could you take advantage of this? Explain.

Answer 1

Hello Sir/ mam

Now, as the 3 year rate is 9%, there is an arbitrage opportunity.

As 3-year rate is higher, hence, 3 year bond must be chearper. Hence, we should buy the 3-year bond, and we should sell a 1 year bond and then sell a 1 year bond 1 year from now and then a 1 year bond 2 years from now.

Hence, by doing this, we get 9% return on the bond whilst we have to pay a 6.997% aggregate on those bonds.

Hence, arbitrage profit arises.

I hope this solves your doubt.

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