Answer:
a. What arbitrage opportunity is available for an investment banking firm?
The arbitrage strategy is to buy zeros with face values of $100 and $1,100, and respective maturities of one year and two years.
This would generate a risk free profit = $4.83
Explanation:
the price of a 2 year bond with annual coupons = PV of maturity value + PV of coupons
($100 / 1.057) + ($1,100 / 1.057²) = $94.61 + $984.56 = $1,079.07
price of a 2 year coupon bond using YTM of zero coupon bonds:
($100 / 1.05) + ($1,100 / 1.06²) = $95.24 + $979 = $1,074.24
risk free profit = $1,079.07 - $1,074.24 = $4.83
