Determine the arbitrage profit (spot rates)

Treasury bonds pay interest twice per year; ½ × 4% × $1,000 = $20.
As for running through it, all of the spot rates are annual (nominal) rates, so you have to divide them by 2 to get the semiannual rates for discounting.
 
Semi-annual coupon payments: (4% * $1,000)/2 = $20
Discount the annual payments with the spot rate. Note that you have to divide the spot rates by two as these are on a semi-annual bond basis.
1. Calculate the PV of the bond at 0 (= arbitrage-free price):
PV=
06m: $20/(1+0.02/2) +
12m: $20/(1+0.025/2)^2 +
18m: $20/(1+0.03/2)^3 +
24m: $20/(1+0.04/2)^4 +
24m: $1,020/(1+0.06/2)^5
= $956.78
Note that this last payment in addition to the coupon also includes the principal value at maturity of 1,000.
2. Compare the arbitrage-free price with the market price of $976 to determine whether there is mispricing yielding to an arbitrage opportunity:
Mispricing = $956.78-$976 = $19.22 (Answer C)
That means that you could by the individual strips (=cash flow streams) for $956.78, reconstruct the bond with these strips and sell it immediately for the market price of $975 ensuring an risk-free profit before transaction costs of $19.22.
 
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