Mock AM: FI Q43

[Halberstram2]

Hake begins development on an algorithm that will evaluate government bonds that have been stripped. He tests his logic by evaluating a dollar-denominated Tangoran government bond with a 3.20%, annual pay coupon maturing in three years, using data in Exhibit 1. The bond is quoted in the market at $103.50.
Based on the market price of the Tangoran government bond and the interest rates in Exhibit 1, what profitable arbitrage opportunity should Hake’s algorithm most likely identify?

Year 1
Year 2
Year 3
Spot Rate
1.10%
1.50%
2.01%
Par Rate
1.10%
1.50%
2.00%
Forward Rate
1.10%
1.91%
3.04%

1. Buying the Year 1 and Year 2 strips and selling the Year 3 strip
2. Buying the bond and selling the strips
3. Buying the strips and selling the bond

Probably a stupid question, but can you explain the answer in a really simple English?

 

[data storm]

simply discount the coupons “3.2” with the spot rates you will see that there’s an arbitrage opportunity as the calculated value will be 103.4816 which is slightly less than the given one, so you buy the strips and sell them to gain the difference.

 

[thoushallpass]

data storm wrote:
simply discount the coupons “3.2” with the spot rates you will see that there’s an arbitrage opportunity as the calculated value will be 103.4816 which is slightly less than the given one, so you buy the strips and sell them to gain the difference.

The answer key does not discount by the spot rates provided. Instead, they discount the second coupon by 1.504% and the final year by 2.013%. I’m very confused by this question/answer too. I feel like I’m missing something elementary here. Any other thoughts on why they discounted by those rates?

 

[Idontsleepistudy]

I think they calculated the spot rates from the Par rate, without rounding them. I used the spot rates and with the 2.01% at the end, i got 103.49$. It’s an insane question but I think you just need the spot rates without rounding.

 

[thoushallpass]

I see, so close enough that it would still lead you to the right answer anyways. I hope that tactic does not lead us astray (by a meaningful margin) this Saturday.