Question

Consider the following bond prices and cash flows: Price Cash Flow Time T 0 1 2 3 Bond A 1246.7 150 200 1250 Bond B 999.8 50 100 1150 Bond C 1001.2 70 1070 0 Bond D 952.3 1000 0 0 Is there an arbitrage opportunity in the above system of prices and cash flows? If so, derive an arbitrage strategy which will generate $1 million profit initially with zero payout at all future dates.

Answer 1

Yes, there is an arbitrage opportunity in the given system of bond prices and cash flows. By buying Bond A and Bond D while simultaneously selling Bond B and Bond C, we can generate a $1 million profit initially with zero payout at all future dates.

Step-by-step explanation:

An arbitrage opportunity exists in the given system of bond prices and cash flows. Arbitrage involves taking advantage of price differences in different markets or instruments to make risk-free profits. In this case, we can exploit the price differences between the bonds to generate a $1 million profit initially with zero payout at all future dates.

To achieve this, we can buy Bond A and Bond D while simultaneously selling Bond B and Bond C. This would create a cash inflow of $1,246.7 (the price of Bond A) + $952.3 (the price of Bond D) and a cash outflow of $999.8 (the price of Bond B) + $1,001.2 (the price of Bond C). This initial cash inflow of $1,246.7 + $952.3 - $999.8 - $1,001.2 = $1,198 would result in a profit of $198.

Since the future cash flows of Bond A and D do not have any value, we can hold these bonds until maturity without any future payout. Therefore, we would keep the full profit of $198 at the end of the investment period.