Question

You can easily buy a 5 year government bond to earn the risk free rate of interest but realized there are other ways to create riskless securities

Show two different combinations of other securities that you could use to replicate the risk free bond

Answer 1

1st Way- An investor can buy a corporate bond and also buy a Credit Default Swap(CDS) on the Same corporate bond. CDS acts like an insurance. Corporate bonds are riskier than Government bonds. CDS help to eliminate the risk as the seller of CDS agrees to for an upfront or continuing premium or fee, to compensate the buyer when a specific event, such as default, restructuring of the bond issuer occurs. So the Corporate bond holder has hedged its risk and is enjoying risk free interest now

2nd way - An Investor can use Total return SWAP. In total return SWAP the total economic exposure, including the market and credit risk of a corporate bond is transfered to another person. The payer of the Total Return Swap is giving away all the exposure of Corporate bond and receiving the exposure of a government bond. So he is hedged fully.