The yield to maturity (YTM) on 1-year zero-coupon bonds is 8% and the YTM on 2-year zeros is 9%. The yield to maturity on 2-year-maturity coupon bonds with coupon rates of 11% (paid annually) is 8.5%.

Required:

a. What arbitrage opportunity is available for an investment banking firm?

b. What is the profit on the activity?

Arbitrage opportunity may exists as the ZCBs selling at different price at same time due to change in their YTM.

The PV of 100 face value zcb with different ytm are different, in this case.

for one year maturity with face value 100 current price = fv / pv at 8% = 92.59

for Two year maturity with face value 100 current price = fv / Pv at 9% for two years = 84.167, if the bond holder sell the bond after 1 year only, the price = 91.74.

a) The arbitrage opportunity exist with buy two bond with face value 100 with maturity of 1 year and face value 110 with maturity of 2 years.

b) profit 0.01, as difference between PV of both bond at their YTM rate.