Problem 1. Fill in the missing items in the following table, using the Law of One Price. Assume all these bonds have the same risk, the yield curve is flat, and any coupon payments are paid annually.
|
Bond #
|
1
|
2
|
3
|
4
|
|
|
1-year
strip bond
|
2-year
strip bond
|
2-year 6% coupon bond
|
2-year 7% coupon bond
|
|
Time 0 cash flow (i.e., Purchase Price for the bond)
|
-950
|
?
|
?
|
?
|
|
Time 1 cash flow
|
+1000
|
0
|
+60
|
+70
|
|
Time 2 cash flow
|
0
|
+1000
|
+1060
|
+1070
|
|
Yield
|
?
|
?
|
5.50%
|
?
|
A. You are considering two investments from the bonds listed in the question above. Show that the cash flows from the following two investments would be identical.
i. 60 units of Bond #1 + 1060 units of Bond #2, and
ii. 1000 units of Bond #3.
B. How many units of Bond #1 and #2 would you need to replicate the cash flows of 1000 units of Bond #4?
C.
i. If the yield of Bond #3 is 5.5%, what would it cost to buy 1000 units of Bond #3?
ii. What would it cost to buy 60 units of Bond #1?
iii. From part A. above, infer the value of 1060 units of Bond #2.
iv. What is the value of one unit of Bond #2? Yield of Bond #2?
D. What's the value of 1000 units of Bond #4? Yield?
E. What have you learned about the Law of One Price from questions above?