(c) (i) 2-years coupon bond

0 1 2
Market value or market price of 2-years coupon bond
=

= $1,018.51




















Timeline





0 1 2
Bond yield Bond price of the zero-coupon bond




0 1



0.1334%

= $12.48




0 1 2




0.3418%

= $1,005.61
Intrinsic value of 2-years coupon bond = $1018.09
$12.5 $1,012.5
$1012.5
$12.5
$12.5
$12.5
$1012.5
4-years coupon bond
Market value or market price of 4-years coupon bond
=

= $1,032.24






















Timeline





0 1 2 3 4
Bond yield Bond price of the zero-coupon bond



0 1

0.1334%

0 1 2
0.3418%

0 1 2 3
0.6712%

0 1 2 3 4
1.0868%

Intrinsic value of 4-years coupon bond = $1031.37
$18.75 $18.75 $18.75
$1,018.75
$18.75
$18.75
$18.75
$18.75 $18.75
$18.75
$18.75 $18.75 $18.75
$1,018.75
(ii) The two U.S. Treasury coupon bonds are overvalued. 2-years coupon bond are
overvalued because the intrinsic value of the coupon bond, $1018.10 is lower than its
market value, $1018.51. As for 4-years coupon bond, it is also overvalued because the
intrinsic value of the coupon bond, $1031.37 is lower than its market value, $1032.24.
So, it is not worth to buy the 2-years and 4-years coupon bond.







































We can pursue the arbitrage profit of 4 years coupon bond by selling the coupon bond.


Sell the coupon bond




0 1 2 3 4




Buy 0.01875 copy of
1-year zero-coupon bond


Buy 0.01875 copy of
2-years zero-coupon bond



Buy 0.01875 copy of
3-years zero-coupon bond


Buy 1.01875 copies of
4-years zero-coupon bond


$1,032.24
$18.75 $18.75 $18.75
$1,018.75
$ 1,000*0.01875
$989.63*0.01875
$1,000*0.01875
$979.37*0.01875
$1,000*0.01875
$969.22*0.01875
$1,000*1.01875
$959.17*1.01875
Use the proceeds from
selling the bond to buy
these bonds
Arbitrage profit
= $1,032.24 ($989.63*0.01875) ($979.37*0.01875) ($969.22*0.01875)
($959.17*1.011875)
= $6.59 (for every coupon bond sold by an investor)







(iii) 4-years coupon bond
Duration =

= 3.89
If the interest rate increases by 1%, the price of the bond will drop by 3.89%.
2-years coupon bond




Duration =

= 1.99
If the interest rate increases by 1%, the price of the bond will drop by 1.99%.
Year (t) Cash Flows PVIF(1.0477%, t) PV PV*t
1 $18.75

$18.56 $18.56
2 $18.75

$18.36 $36.72
3 $18.75

$18.17 $54.51
4 $1018.75

$977.15 $3,908.60
Total = $1,032.24 $4,018.39
Year (t) Cash Flows PVIF(0.3199%, t) PV PV*t
1 $12.5

$12.46 $12.46
2 $1,012.5

$1,006.05 $2,012.10
Total = $1,018.51 $2,024.56