Question: Construct a Replicating Portfolio (RP) to replicate a 1.5-year Bond-0 that pays 15 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 13 percent coupon per year, and a 1-year Bond-3 which pays 17 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 109, 93.5, 102.25 and 112.8.
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. Is Bond-0 to be held long or short in arbitrage trading strategy.
7. Is Bond-1 to be held long or short in an arbitrage trading strategy.
8. Is Bond-2 to be held long or short in an arbitrage trading strategy.
9. Is Bond-3 to be held long or short in an arbitrage trading strategy.