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You have identified a pure bond arbitrage strategy: bond C is overvalued and the replicating portfolio...

You have identified a pure bond arbitrage strategy: bond C is overvalued and the replicating portfolio is undervalued. You present your findings to your team. Your boss is worried that the trading strategy involves short-selling bond C which might expose the firm to future cash-outflows. Explain to your boss why the strategy will yield a risk-free profit.

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Answer #1

A replicating portfolio is nothing but synthetically creating bond C. Using law of one price, both portfolios must have same price. However, if one portfolio is undervalued than the other, there is a possibility of arbitrage. One can lock in risk free profits by selling the overvalued portfolio and buying the undervalued portfolio. This does not expose to any risk because all cash flows of one portfolio are matched with the other portfolio. Therefore, those cash flows can be used to service future outflows if any.

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