Finance-Construct a Replicating Portfolio (RP) to replicate a 1.5-year

| January 30, 2017

Question
Need detailed calculations for the following:

Construct a Replicating Portfolio (RP) to replicate a 1.5-year
Bond-0 that pays 6.9 percent of coupon per year.

The available bonds for replication are: a one year zero coupon Bond-1, a 1.5-year Bond-2 that pays 4.9 percent coupon per year, and a 1-year Bond-3 which pays 8.9 percent coupon per year. All the bonds (Bond-0, Bond-1, Bond-2, and Bond-3) have
the same face value of $100 and pay their annual coupons two times a year.

Compute an arbitrage trading strategy to generate profits, if any, when the current market prices of the four bonds, respectively, are 100.9, 97.55, 100.22 and 103.08.

1. What is the dollar face value of Bond-1 in the RP?
2. What is the dollar face value of Bond-2 in the RP?

3. What is the dollar face value of Bond-3 in the RP?
4. What is the cost of the RP?
5. What is the arbitrage fair price of Bond-0?

6. Is Bond-0 to be held long or short in arbitrage trading strategy.
7. Is Bond-1 to be held long or short in an arbitrage trading strategy.
8. Is Bond-2 to be held long or short in an arbitrage trading strategy.
9. Is Bond-3 to be held long or short in an arbitrage trading strategy.

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