In part a, the value of a 6.6% 8-year treasury issue can be calculated by discounting the future cash flows at the prevailing treasury spot rate curve. The value is the present value of the future cash flows, which equals $1000. In part b, the price of the 6.6% 8-year treasury issue based on a 5.7% discount rate can be calculated by discounting each cash flow at the yield rate. The price is the present value of the future cash flows, which equals $1064.50. In part c, a dealer would buy the bond at the lower market price and sell it at the higher arbitrage-free value price, resulting in an arbitrage profit of $64.50. In part d, the market price will not differ materially from the arbitrage-free value due to the efficiency of arbitrage and market forces.
In part a, the value of a 6.6% 8-year treasury issue can be calculated by discounting the future cash flows at the prevailing treasury spot rate curve. The value is the present value of the future cash flows, which equals $1000.
In part b, the price of the 6.6% 8-year treasury issue based on a 5.7% discount rate can be calculated by discounting each cash flow at the yield rate. The price is the present value of the future cash flows, which equals $1064.50.
In part c, if the market price is based on the price found in part b, a dealer would buy the bond at the lower price and sell it at the higher arbitrage-free value price, resulting in an arbitrage profit of $64.50.
In part d, the market price will not differ materially from the arbitrage-free value due to the efficiency of arbitrage and market forces that lead to price convergence.