Suppose that the three-year rate is 6%, the five-year rate is 7% (both expressed with annual compounding), the daily volatility of a three-year zero-coupon bond is 0.6%, and the daily volatility of a five-year zero-coupon bond is 0.8%. The correlation between daily returns on the two bonds is 0.6. Map a cash flow of $1,000 received at time 3.5 years into a position in a three-year bond and a position in a five-year bond. What cash flows in three and five years are equivalent to the 3.5-year cash flow?
There are 3 stages