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Price of bond, Replicating portfolio using Zero Coupon Bonds

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(a) What is the price of a 15% coupon bond with par value of $120 if it matures in 4 years from now and pays the coupon semi-annually? Assume that the annual percentage rate is 11%.

(b) If we think of the cash flows from this bond as a portfolio of zero coupon bonds that mature every six months, then it is possible to construct a replicating portfolio by purchasing zeros. Assume that you can easily purchase zeros (zero coupon bonds) with par values of $3 from the market. Show how the bond in (a) above can be valued by replicating it with a portfolio of zeros. If the price of this bond is $140, is there an arbitrage opportunity? Explain.

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Solution Summary

The solution calculates the price of a bond and demonstrates how a coupon bond can be valued by replicating it with a portfolio of zeros.

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