The yield to maturity (YTM) on 1-year zero-coupon bond is 5% and the YTM on 2-year zeros is 6%. The yield to maturity on 2-year maturity coupon bonds with coupon rates of 12% (paid annually) is 5.8%. What arbitrage opportunity is available for a fixed income trader? What is the profit of this activity? Please explain your strategy and your trading activity.

2.91

Explanation:

Price of the 2 year maturity coupon bond:

Coupon payment = 1000 * 12% = 120

Price = 120 / ( 1+5.8% ) 1 + 1120 / ( 1+5.8% ) 2 = 1113.99

Price of the zero coupon bond:

Price = 120 / ( 1+5% ) 1 + 1120 / ( 1+6% ) 2 = 1111.08

The arbitrage opportunity will involve buy the zeroes at the face value of $120 and $1120 and sell the 2 year coupon bond.

Profit = 1113.99 -1111.08 = 2.91

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