Final answer:
An arbitrage opportunity exists when a firm can profit from discrepancies in yield to maturity on different bonds. By buying zero-coupon bonds and selling coupon bonds, a profit can be locked in due to the yield differences, exploiting the capital gains potential when interest rates vary.
Step-by-step explanation:
An investment banking firm can exploit an arbitrage opportunity given the difference in yield to maturity (YTM) among various bonds. The YTMs mentioned are 5% for 1-year zero-coupon bonds, 6% for 2-year zeros, and 5.8% on 2-year coupon bonds with a 12% coupon rate. The opportunity lies in creating a series of transactions that take advantage of the difference between the yields of these bonds.
Arbitrage involves simultaneously buying and selling securities in different markets or forms to profit from the price differences. The given situation suggests that by buying the zero-coupon bonds and financing them through selling the coupon bonds, one could lock in a profit due to the differing YTMs. Investing in a bond with a lower YTM and funding it by borrowing at a higher YTM creates the potential for gain.
When analyzing bond arbitrage opportunities, it's important to note the total return, which includes not just the coupon or interest payments but also any capital gains. If interest rates rise, existing bonds with lower rates sell for less than face value, and the opposite is also true. The discrepancy in YTMs among the bonds presents a chance to buy undervalued securities and sell overvalued ones, which is the essence of arbitrage.