Question #6
Reading: Reading 25 The Term Structure and Interest Rate Dynamics
PDF File: Reading 25 The Term Structure and Interest Rate Dynamics.pdf
Page: 2
Status: Correct
Correct Answer: A
Question
Jorgen Welsher, CFA obtains the following quotes for zero coupon government bonds all with a par value of $100. Type of Price Delivery (years) Maturity (years) Price Spot 0 3 $91.51 Forward 2 3 $94.55 Spot 0 2 $92.45 Welsher can earn arbitrage profits by:
Answer Choices:
A. buying the 2-year bond in the spot market, going long the forward contract and selling the 3-year bond in the spot market
B. buying the 2-year bond in the spot market, going short the forward contract and selling the 3-year bond in the spot market
Explanation
F(2,1) = P3/P2 = $98.98 but is quoted at $94.55 and hence is cheap – buy it. A combination
of a long position in the 2-year spot market, rolled over for 1 year at a locked-in forward
rate (i.e., a long position in forward), would generate a return higher than the quoted 3-
year spot rate.