Purchase Solution

Bond pricing using zero coupon bonds

Not what you're looking for?

Ask Custom Question

A 7% annual coupon bond (face value $1,000), with three years left till maturity is selling for $986.90. Zero-coupon bonds of 1, 2, 3 years maturity (all with face value of $1,000) sell for $950, $900, $820,respectively. Is this coupon bond properly priced? If not, show an arbitrage transaction to profit $2000 (today) from the mispricing.

I'm not given the market interest rate, and struggling with BA2 plus on this one. Please help.

Purchase this Solution

Solution Summary

Prices a coupon bond using zero-coupon bonds and exploits an arbitrage opportunity because of mispricing.

Solution Preview

Please see the attached file:
A 7% annual coupon bond (face value $1,000), with three years left till maturity is selling for $986.90.Zero-coupon bonds of 1, 2, 3 years maturity (all with face value of $1,000) sell for $950, $900, $820,respectively. Is this coupon bond properly priced? If not, show an arbitrage transaction to profit $2000(today) from the mispricin.

We can price the coupon bond using the discount factor (present value factor) derived from the zero- coupon bonds

Zero coupon bonds
Face Value= $1,000
Present value factor
1 year $950 0.95 =$1,000 / $950
2 year $900 0.90 =$1,000 / $900
3 year $820 0.82 =$1,000 / $820

Now that have got the discount factor we can price the coupon bond

Face Value = $1,000
Coupon = 7% = 7.% x $1,000
Annual interest ...

Purchase this Solution


Free BrainMass Quizzes
Basic Social Media Concepts

The quiz will test your knowledge on basic social media concepts.

Organizational Leadership Quiz

This quiz prepares a person to do well when it comes to studying organizational leadership in their studies.

Motivation

This tests some key elements of major motivation theories.

Understanding the Accounting Equation

These 10 questions help a new student of accounting to understand the basic premise of accounting and how it is applied to the business world.

Organizational Behavior (OB)

The organizational behavior (OB) quiz will help you better understand organizational behavior through the lens of managers including workforce diversity.