Construct a Replicating Portfolio (RP) to replicate a 1.5-year Bond-0 that pays 11.59 percent of coupon per year. The available bonds for replication are: a one year zero coupon Bond-1, a 1.5-year Bond-2 that pays 9.59 percent coupon per year, and a 1-year Bond-3 which pays 13.59 percent coupon per year. All the bonds (Bond-0, Bond-1, Bond-2, and Bond-3) have the same face value of $100 and pay their annual coupons two times a year. Compute an arbitrage trading strategy to generate profits, if any, when the current market prices of the four bonds, respectively, are 105.59, 95.21, 101.4 and 108.7. Show work.
1. What is the dollar face value of Bond-1 in the RP?
2. What is the dollar face value of Bond-2 in the RP?
3. What is the dollar face value of Bond-3 in the RP?
4. What is the cost of the RP?
5. What is the arbitrage fair price of Bond-0?
6. Write 1 if Bond-0 is to be held long and 0 if Bond-0 is to be held short in arbitrage trading strategy.
7. Write 1 if Bond-1 is to be held long and 0 if Bond-1 is to be held short in an arbitrage trading strategy.
8. Write 1 if Bond-2 is to be held long and 0 if Bond-2 is to be held short in an arbitrage trading strategy.
9. Write 1 if Bond-3 is to be held long and 0 if Bond-3 is to be held short in an arbitrage trading strategy.