The yield to maturity (YTM) on 1-year zero-coupon bonds 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 10% (paid annually) is 5.7%. a. What arbitrage opportunity is available for an investment banking firm? The arbitrage strategy is to buy zeros with face values of $ and $, and respective maturities of one year and two years.

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