Chapter 03 - Valuing Bonds

CHAPTER 3
Valuing Bonds
The values shown in the solutions may be rounded for display purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.

Answers to Problem Sets

1. a. Does not change. The coupon rate is set at time of issuance.

b. Price falls. The yield to maturity and the price are inversely related.

c. Yield to maturity rises. Since the price falls, the bond’s yield to maturity will rise.

Est. Time: 01-05

2. a. If the coupon rate is higher than the yield to maturity, then investors must be
expecting a decline in the capital value of the bond over its remaining life. Thus, the
bond’s price must be greater than its face value.

b. Conversely, if the yield to maturity is greater than the coupon, the price will be below
face value. The price will rise and equal face value at maturity.

Est. Time: 01-05

3. Semiannual discount rate = .027 / 2 = .0135, or 1.35%

Number of time periods = (2041 – 2015) × 2 = 52

PV = [(.0475 × $1,000) / 2] × ((1 / .0135) – {1 / [.0135 × (1 + .0135)52]}) + $1,000 / (1 + .0135)52

PV = $1,381.20

Est. Time: 01-05

4. PV = (.05 × €100) × ((1 / .06) – {1 / [.06 × (1 + .06)10]}) + €100 / (1 + .06)10

PV = €92.64

Est. Time: 01-05

5. a. Fall. Assume a one-year, 10 percent bond. If the interest rate is 10

percent, the bond is worth $110 / 1.1 = $100. If the interest rate rises to 15 percent, the
bond is worth $110 / 1.15 = $95.65.

b. Less. Using the example in part a, if the bond yield to maturity is 15 percent but the
coupon rate is lower at 10 percent, the price of the bond is less than $100.

c. Less. If r = 5 percent, then a 1-year 10 percent bond is worth $110 / 1.05 = $104.76.

d. Higher. If r = 10 percent, a 1-year 10 percent bond is worth $110 / 1.1 = $100, while a 1-
year 8 percent bond is worth $108 / 1.1 = $98.18.

e. No. Low-coupon bonds have longer durations (unless there is only one
period to maturity) and are therefore more volatile. For example. if r falls from 10 percent

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Chapter 03 - Valuing Bonds

to 5 percent, the value of a 2-year 10 percent annual coupon bond rises from $100 to
$109.30, which is an increase of 9.3 percent. The value of a 2-year 5 percent annual
coupon bond rises from $91.32 to $100, which is an increase of 9.5 percent.

Est. Time: 01-05

6. a. Spot interest rates. Yield to maturity is a complicated average of the separate spot rates
of interest.

b. Bond prices. The bond price is determined by the bond’s cash flows and the spot rates of
interest. Once you know the bond price and the bond’s cash flows, it is possible to
calculate the yield to maturity.
c.
Est. Time: 01-05

7. a. 4%; each bond will have the same yield to maturity.

b. PV = $80 / (1.04) + $1,080 / (1.04)2

PV = $1,075.44

Est. Time: 01-05

8. a. PV = (.05 × $1,000) / (1 + r1) + [(.05 × $1,000) + $1,000] / (1 + r2)2

b. PV = (.05 × $1,000) / (1 + y) + [(.05 × $1,000) + $1,000] / (1 + y)2

c. Less; it is between the 1-year and the 2-year spot rates.

Est. Time: 01-05

9. a. The 2-year spot rate is r2 = (100 / 99.523).5 – 1 = .24%.

The 3-year spot rate is r3 = (100 / 98.937)1/3 – 1 = .36%.
The 4-year spot rate is r4 = (100 / 97.904).25 – 1 = .53%.
The 5-year spot rate is r5 = (100 / 96.034).2 – 1 = .81%.

b. Upward-sloping.

c. Higher; the yield on the

bond is a complicated average of the separate spot rates.

Est. Time: 01-05

10. a. PV0 = (.08 × $100) × ((1 / .06) – {1 / [.06(1 + .06)5]}) + $100 / 1.065
PV0 = $108.42

PV1 = (.08 × $100) × ((1 / .06) – {1 / [.06(1 + .06)4]}) + $100 / 1.064

PV1 = $106.93

b. Return = [(.08 × $1,000) + $106.93 – 108.42] / $108.42 = .06, or 6%

c. If a bond’s yield to maturity is unchanged over the period, the annual return to the
bondholder is equal to the yield to maturity.

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Chapter 03 - Valuing Bonds

Est. Time: 01-05

11. a. False. Duration depends on the coupon as well as the maturity.

b. False. Given the yield to maturity, volatility is proportional to duration.

c. True. A lower coupon rate means longer duration and therefore higher volatility.

d. False. A higher interest rate reduces the relative present value of distant principal
repayments.

Est. Time: 01-05

12.

Volatility
Proportion =
of Total Proportion (Duration
Year Ct PV(Ct) Value × Time / (1 + r)
r = 8%

Security A 1 40 37.04 .3593 .3593

2 40 34.29 .3327 .6654
3 40 31.75 .3080 .9241
Total PV = 103.08 1.0000 Duration = 1.9487 1.80

Security B 1 20 18.52 .1414 .1414

2 20 17.15 .1310 .2619
3 120 95.26 .7276 2.1828
Total PV = 130.93 1.0000 Duration = 2.5861 2.39

Security C 1 10 9.26 .0881 .0881

2 10 8.57 .0815 .1631
3 110 87.32 .8304 2.4912
Total PV = 105.15 1.00 Duration = 2.7424 2.54

Est. Time: 06-10

13. 1-year rate in 1 year = 1.062 / 1.05 – 1

1-year rate in 1 year = .0701, or 7.01%

Est. Time: 01-05

14. a. r = 1.10 / 1 .05 – 1

r = .0476, or 4.76%

b-1. The real rate does not change.

b-2. The nominal rate increases to:

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Chapter 03 - Valuing Bonds

rNominal = 1.0476 × 1.07 – 1

rNominal = .1210, or 12.10%

Est. Time: 01-05

15. Using Excel:

Bond 1 YTM = 4.30%

Bond 2 YTM = 4.20%
Bond 3 YTM = 3.90%

Bond 1 Duration = 9.05

Bond 2 Duration = 8.42
Bond 3 Duration = 7.65

Est. Time: 01-05

16. a. PV = (.0275 × $1,000) × ((1 / .026) – {1 / [.026(1 + .026)10×2 ]}) + $1,000 / (1 + .026)10×2
PV = $1,023.16

b.
Yield to
PV of Bond
Maturity
1% $1,427.22
2% 1,315.80
3% 1,214.60
4% 1,122.64
5% 1,038.97
6% 962.81
7% 893.41
8% 830.12
9% 772.36
10% 719.60
11% 671.36
12% 627.23
13% 586.81
14% 549.75
15% 515.76

Est. Time: 06-10

17. One-year rate of 3 percent:

P0 = (.05 × $1,000) × ((1 / .03) – {1 / [.03(1 + .03)6]}) + $1,000 / (1 + .03)6

P0 = $1,108.34

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Chapter 03 - Valuing Bonds

P1 = (.05 × $1,000) × ((1 / .03) – {1 / .03(1 + .03)5]}) + $1,000 / (1 + .03)5

P1 = $1,091.59

r = [(.05 × $1,000) + $1,091.59 – 1,108.34] / $1,108.34

r = .0300, or 3.00%

One year rate of 2 percent:

P0 = (.05 × $1,000) × ((1 / .03) – {1 / [.03(1 + .03)6]}) + $1,000 / (1 + .03)6

P0 = $1,108.34

P1 = (.05 × $1,000) × ((1 / .02) – {1 / [.02(1 + .02)5]}) + $1,000 / (1 + .02)5

P1 = $1,141.40

r = [(.05 × $1,000) + $1,141.40 – 1,108.34] / $1,108.34

r = .0749, or 7.49%

Est. Time: 06-10

18. The key here is to find a combination of these two bonds (i.e., a portfolio of bonds) that has a
cash flow only at t = 6. Then, knowing the price of the portfolio and the cash flow at t = 6, we can
calculate the six-year spot rate. We begin by specifying the cash flows of each bond and using
these and their yields to calculate their current prices:

Investment Yield C1 ... C5 C6 Price

6% bond 12% 60 ... 60 1,060 $753.32
10% bond 8% 100 ... 100 1,100 $1,092.46

From the cash flows in years 1 through 5, we can see that buying two 6 percent bonds produces
the same annual payments as buying 1.2 of the 10 percent bonds. To see the value of a cash
flow only in year 6, consider the portfolio of two 6 percent bonds minus 1.2 10 percent bonds.
This portfolio costs:

($753.32 × 2) – (1.2 × $1,092.46) = $195.68

The cash flow for this portfolio is equal to zero for years 1 through 5 and, for year 6, is equal to:

($1,060 × 2) – (1.2 × $1,100) = $800

Thus:
$195.68 × (1 + r6)6 = $800

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Chapter 03 - Valuing Bonds

r6 = .2645, or 26.45%

Est. Time: 06-10

19. Downward sloping. This is because high-coupon bonds provide a greater proportion of their cash
flows in the early years. In essence, a high-coupon bond is a “shorter” bond than a low-coupon
bond of the same maturity.

Est. Time: 01-05

20. a.
Year Discount factor
1 1 / 1.05 = .952
2 1 / (1.054)2 = .900
3 1/ (1.057)3 = .847
4 1 / (1.059)4 = .795
5 1 / (1.060)5 = .747

b. i. 5 percent, two-year bond:

PV = $50 / 1.05 + $1,050 / 1.0542

PV = $992.79

ii. 5 percent, five-year bond:

PV = $50 / 1.05 + $50 / 1.0542 + $50 / 1.0573 + $50 / 1.0594 + $1,050 / 1.0605
PV = $959.34

iii. 10 percent, five-year bond:

PV = $100 / 1.05 + $100 / 1.0542 + $100 / 1.0573 + $100 / 1.0594 + $1,100 /

1.0605
PV = $1,171.43

c. First, we calculate the yield for each of the two bonds. For the 5 percent bond, this
means solving for r in the following equation:

$959.34 = $50 / (1 + r) + $50 / (1 + r)2 + $50 / (1 + r)3 + $50 / (1 + r)4 + $1,050 /

(1 + r)5
r = .05964, or 5.964%

For the 10% bond:

$1,171.43 = $100 / (1 + r) + $100 / (1 + r)2 + $100 / (1 + r)3 + $100 / (1 + r)4 +

$1,100 / (1 + r)5

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Chapter 03 - Valuing Bonds

r = .05937, or 5.937%

The yield depends upon both the coupon payment and the spot rate at the time of the
payment. The 10 percent bond has a slightly greater proportion of its total payments coming
earlier, when interest rates are low, than does the 5 percent bond. Thus, the yield of the 10
percent bond is slightly lower.

d. The yield to maturity on a five-year zero-coupon bond is the five-year spot rate, which is
6.0 percent.

e. First, we find the price of the five-year annuity, assuming that the annual payment is $1:

PV = $1 / 1.05 + $1/ 1.0542 + $1 / 1.0573 + $1 / 1.0594 + $1 / 1.0605

PV = $4.2417

Now we find the yield to maturity for this annuity:

$4.2417= $1 / (1 + r) + $1 / (1 + r)2 + $1 / (1 + r)3 + $1 / (1 + r)4 + $1 / (1 + r)5

r = .0575 or 5.75%

f. The yield on the five-year note lies between the yield on a five-year zero-coupon bond
and the yield on a five-year annuity because the cash flows of the Treasury bond lie
between the cash flows of these other two financial instruments during a period of rising
interest rates. That is, the annuity has fixed, equal payments; the zero-coupon bond has
one payment at the end; and the bond’s payments are a combination of these.

Est. Time: 06-10

21. To calculate the duration, consider the following table similar to Table 3.4:

Year 1 2 3 4 5 6 7 Totals
Payment ($) 30 30 30 30 30 30 1,030
PV(Ct) at 4% ($) 28.846 27.737 26.670 25.644 24.658 23.709 782.715 939.979
Fraction of total value
[PV(Ct)/PV] .031 .030 .028 .027 .026 .025 .833 1.000
Year × fraction of total value .031 .059 .085 .109 .131 .151 5.829
Duration (Years) 6.395

The duration is the sum of the year × fraction of total value row, or 6.395 years.

The modified duration, or volatility, is 6.395 / (1 + .04) = 6.15.

The price of the 3 percent coupon bond at 3.5 percent, and 4.5 percent equals $969.43 and
$911.61, respectively. The price difference is $57.82, or 6.15 percent of the bond’s value at the 4
percent discount rate. The percentage difference is equal to the 1 percent change in the discount
rate × modified duration.

Est. Time: 06-10

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Chapter 03 - Valuing Bonds

22.
a. If the bond coupon payment changes from 9% as listed in Table 3.4 to 8%, then the
following calculation for duration can be made:

Year 1 2 3 4 5 a. 7 Totals
Payment ($) 80 80 80 80 80 80 1,080
PV(Ct) at 4% ($) 76.923 73.964 71.120 68.384 65.754 63.225 820.711 1,240.082
Fraction of total value
[PV(Ct)/PV] .062 .060 .057 .055 .053 .051 .662 1.000
Year × fraction of total value .062 .119 .172 .221 .265 .306 4.633
Duration (years) 5.778

A decrease in the coupon payment will increase the duration of the bond, as the duration at an 8
percent coupon payment is 5.778 years.

The volatility for the bond in Table 3.4 with an 8 percent coupon payment is: 5.778 / 1.04 = 5.556.
The bond therefore becomes less volatile if the coupon payment decreases.

b. For a 9 percent bond whose yield increases from 4 percent to 6 percent, the duration can
be calculated as follows:

Year 1 2 3 4 5 6 7 Totals
Payment ($) 90 90 90 90 90 90 1090
PV(Ct) at 6% ($) 84.906 80.100 75.566 71.288 67.253 63.446 724.912 1,167.471
Fraction of total value
[PV(Ct)/PV] .073 .069 .065 .061 .058 .054 .621 1.000
Year × fraction of total value .073 .137 .194 .244 .288 .326 4.346
Duration (years) 5.609

There is an inverse relationship between the yield to maturity and the duration. When the yield
goes up from 4 percent to 6 percent, the duration decreases slightly. The volatility can be
calculated as follows: 5.609 / 1.06 = 5.291. This shows that the volatility decreases as well when
the yield increases.

Est. Time: 06-10

23. The duration of a perpetual bond is: [(1 + yield) / yield].

The duration of a perpetual bond with a yield of 5% is:

D5 = 1.05 / .05 = 21 years

The duration of a perpetual bond yielding 10 percent is:

D10 = 1.10 / .10 = 11 years

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Chapter 03 - Valuing Bonds

Because the duration of a zero-coupon bond is equal to its maturity, the 15-year zero-coupon
bond has a duration of 15 years.
Thus, comparing the 5 percent perpetual bond and the 15-year zero-coupon bond, the 5 percent
perpetual bond has the longer duration. Comparing the 10 percent perpetual bond and the 15-
year zero, the zero has a longer duration.

Est. Time: 06-10

24. Answers will differ. Generally, we would expect yield changes to have the greatest impact on
long-maturity and low-coupon bonds.

Est. Time: 06-10

25. The new calculations are shown in the table below:

1 2 3 4 Bond Price (PV) YTM (%)

Spot rates (%) 4.60 4.40 4.20 4.00

Discount factors .9560 .9175 .8839 .8548

Bond A (8% coupon):

Payment (Ct) $80 $1,080
PV(Ct) $76.48 $990.88 $1,067.37 4.407%

Bond B (8% coupon):

Payment (Ct) $80 $80 $1,080
PV(Ct) $76.48 $73.40 $954.60 $1,104.48 4.219%

Bond C (8% coupon):

Payment (Ct) $80 $80 $80 $1,080
PV(Ct) $76.48 $73.40 $70.71 $923.19 $1,143.78 4.036%

26. We will borrow $1,000 at a five-year loan rate of 2.5% and buy a four-year strip paying 4%. We
may not know what interest rates we will earn on the last year, but we can put it under our
mattress earning 0 percent, if necessary, to pay off the loan when it comes due.

Using the information from problem 25, the cost of the strip will be $1,000 × .8548 = $854.80. The
proceeds from the 2.5 percent loan = $1,000 / (1.025)5 = $883.85. We can pocket the difference
of $29.05, smile, and repeat.

The minimum sensible value would be to set the discount factor used in year 5 equal to that of
year 4, which would assume a 0 percent interest rate for year 5. We can solve for the interest rate
where 1 / (1 + r)5 = .8548, which is roughly 3.19%.

Est. Time: 06-10

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Chapter 03 - Valuing Bonds

27.
a. Based on a $100 investment:

$100 × (1 + .042)3 = $113.137

$100 × (1 + .04)4 = $116.986

1-year spot rate in three years:

($116.986 – 113.137) / $113.137 = .034, or 3.4%

b. If investing in long-term bonds carries additional risks, then the risk equivalent of a one-
year spot rate in three years would be less that the 3.4 percent, reflecting the fact that
some risk premium must be built into this 3.4 percent spot rate.

Est. Time: 06-10

28.
a. Nominal 2-year return:

1.082 – 1 = .1664, or 16.64%

Real 2-year return:

(1.08 / 1.03) × (1.08 / 1.05) – 1 = .0785, or 7.85%

b. Nominal 2-year return:

1.082 – 1 = .1664, or 16.64%

Real 2-year return:

(1.08 × 1.03) × (1.08 × 1.05) – 1 = .2615, or 26.15%

Est. Time: 01-05

29. PV = (.10 × $1,000) × ((1 / .034) – {1 / [.034(1 + .034)5]}) + $1,000 / 1.0345

PV = $1,298.84

PV = (.10 × $1,000) × ((1 / .044) – {1 / [.044(1 + .044)5]}) + $1,000 / 1.0445

PV = $1,246.53

30. Answers will vary by the interest rates chosen.

a. Suppose the YTM on a four-year 3 percent coupon bond is 2 percent:

PV = (.03 × $1,000) × ((1 / .02) – {1 / [.02(1 + .02)4]}) + $1,000 / (1 + .02)4

PV = $1,038.08

If the YTM stays the same, one year later the bond will sell for:

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Chapter 03 - Valuing Bonds

PV = (.03 × $1,000) × ((1 / .02) – {1 / [.02(1 + .02)3]}) + $1,000 / (1 + .02)3

PV = $1,028.84

r = ($30 + 1,028.84 – 1,038.08) / $1,038.08

r = .02, or 2%, which is equal to the yield to maturity

b. Suppose the YTM on a four-year 3 percent coupon bond is 4 percent:

PV = (.03 × $1,000) × ((1 / .04) – {1 / .04 × (1 + .04)4]}) + $1,000 / (1 + .04)4

PV = $963.70

If the YTM stays the same, one year later the bond will sell for:

PV = (.03 × $1,000) × ((1 / .04) – {1 / .04 × (1 + .04)3]}) + $1,000 / (1 + .04)3

PV = $972.25

r = ($30 + 972.25 – 963.70) / $963.70

r = .04, or 4%, which is equal to the yield to maturity

Est. Time: 06-10

31. Spreadsheet problem; answers will vary.

Est. Time: 06-10

32. Arbitrage opportunities can be identified by finding situations where the implied forward rates or
spot rates are different.
We begin with the shortest-term bond, Bond G, which has a two-year maturity. Since G is a zero-
coupon bond, we determine the two-year spot rate directly by finding the yield for Bond G. The
yield is 9.5%, so the implied two-year spot rate (r2) is 9.5 percent. Using the same approach for
Bond A, we find that the three-year spot rate (r3) is 10.0 percent.
Next we use Bonds B and D to find the four-year spot rate. The following position in these bonds
provides a cash payoff only in year four: a long position in two of Bond B and a short position in
Bond D.

Cash flows for this position are:

[(–2 × $842.30) + $980.57] = –$704.03 today

[(2 × $50) – $100] = $0 in years 1, 2 and 3
[(2 × $1,050) – $1,100] = $1,000 in year 4

We determine the four-year spot rate from this position as follows:

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Chapter 03 - Valuing Bonds

$1,000
$704.03 =
(1 + r4 ) 4
r4 = .0917 = 9.17%

Next, we use r2, r3, and r4 with one of the four-year coupon bonds to determine r1. For Bond C:

$1,065.28 = $120 / (1 + r1) + $120 / 1.0952 + $120 / 1.1003 + $1,120 / 1.09174

r1 = .3867 = 38.67%

Now, in order to determine whether arbitrage opportunities exist, we use these spot rates to value
the remaining two four-year bonds. This produces the following results: for Bond B, the present
value is $854.55, and for Bond D, the present value is $1,005.07. Since neither of these values
equals the current market price of the respective bonds, arbitrage opportunities exist. Similarly,
the spot rates derived above produce the following values for the three-year bonds: $1,074.22 for
Bond E and $912.77 for Bond F.

Est. Time: 11-15

33. We begin with the definition of duration as applied to a bond with yield r and an annual payment
of C in perpetuity:

1C 2C 3C tC
+ + +L+ +L
1 + r (1 + r) (1 + r)
2 3
(1 + r)t
DUR =
C C C C
+ + +L+ +L
1 + r (1 + r) (1 + r)
2 3
(1 + r)t
We first simplify by dividing both the numerator and the denominator by C:

1 2 3 t
+ + +L + +L
(1 + r) (1 + r) (1 + r)
2 3
(1 + r)t
DUR =
1 1 1 1
+ + +L + +L
1 + r (1 + r) (1 + r)
2 3
(1 + r)t

The denominator is the present value of a perpetuity of $1 per year, which is equal to (1/r). To
simplify the numerator, we first denote the numerator S and then divide S by (1 + r):

S 1 2 3 t
= + + + L+ + 1
+L
(1 + r) (1 + r) (1 + r) (1 + r)
2 3 4
(1 + r)t

Note that this new quantity [S/(1 + r)] is equal to the square of denominator in the duration
formula above, that is:
2
S  1 1 1 1 
=  + + + L+ + L
(1 + r)  1 + r (1 + r) (1 + r)
2 3
(1 + r)t


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Chapter 03 - Valuing Bonds

Therefore:
2
S  1 1+ r
=   ⇒ S= 2
(1 + r)  r  r
Thus, for a perpetual bond paying C dollars per year:

1+ r 1 1+ r
DUR = 2
× =
r (1 / r) r
Est. Time: 06-10

34. One solution is:

Solve for r1:

$97.56 = $100 / (1 + r)
r1 = .025, or 2.50%

Solve for r4:

$87.48 = $100 / (1 + r)4

r4 = .034, or 3.40%

Solve for r5:

Using 1.5 times the 2 percent coupon bond and the 3 percent coupon bond, the cash flows for
years 1-4 will be eliminated so you can solve for r5:

(1.5 × $928.90) – $974.30 = [(1.5 × $1,020) – 1,030] / (1 + r5)5

r5 = .035955, or 3.5955%

Solve for r3:

Reduce the 5-year 2 percent coupon bond using r1, r4, and r5:

$928.90 = $20 / 1.025 + $20 / (1 + r2)2 + $20 / (1 + r3)3 + $20 / 1.0344 + $1,020 / 1.0359555
$37.030021 = $20 / (1 + r2)2 + $20 / (1 + r3)3

Reduce the 3-year 5 percent coupon bond using r1:

$1,054.20 = $50 / 1.025 + $50 / (1 + r2)2 + $1,050 / (1 + r3)3

$1,005.419512 = $50 / (1 + r2)2 + $1,050 / (1 + r3)3

Using the reduced 3-year bond and 2.5 times the reduced 5-year 2 percent coupon bond will
eliminate the year 2 cash flows, so you can solve for r3:

$1,005.419512 – (2.5 × $37.030021) = ($1,050 – (2.5 × $20) / (1 + r3)3

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Chapter 03 - Valuing Bonds

$912.844459 / $1,000 / (1 + r3)3

r3 = .030863, or 3.0863%

Solve for r2:

Using the 3-year bond and r1 and r3, solve for r2:

$1,054.20 = $50 / 1.025 + $50 / (1 + r2)2 + $1,050 / 1.0308633

$46.932036 = $50 / (1 + r2)2
r2 = .0322

Thus, the spot rates for years 1 to 5 are 2.50 percent, 3.22 percent, 3.09 percent, 3.40 percent,
and 3.60 percent, respectively.

Est. Time: 16-30

35. a. We can set up the following three equations using the prices of bonds A, B, and C:

Using bond A: $1,076.19 = $80 / (1 + r1) + $1,080 /(1 + r2)2

Using bond B: $1,084.58 = $80 / (1 + r1) + $80 / (1 + r2)2 + $1,080 / (1 + r3)3
Using bond C: $1,076.20 = $80 / (1 + r1) + $80 / (1 + r2)2 + $80/ (1 + r3)3 + $1,080 /
(1 + r4)4

We know r4 = 6 percent so we can substitute that into the last equation. Now we have
three equations and three unknowns and can solve this with variable substitution or linear
programming to get r1 = 3 percent, r2 = 4 percent; r3 = 5 percent, r4 = 6 percent.

b. We will want to invest in the underpriced C and borrow money at the current spot market
rates to construct an offsetting position. For example, we might borrow $80 at the one-
year rate of 3 percent, $80 at the two-year rate of 4 percent, $80 at the three-year rate of
5 percent, and $1,080 at the four-year rate of 6 percent. Of course the PV amount we will
receive on these loans is $1,076.20. Now we purchase the discounted bond C at $1,040
and use the proceeds of this bond to repay our loans as they come due. We can pocket
the difference of $36.20, smile, and repeat.
Est. Time: 11-15

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McGraw-Hill Education.