# Answer to Question #70638 in Finance for Nick Mango

Question #70638

• A coupon bond with a coupon rate of 8% and a face value of $1,000. Coupons

are paid out annually and the bond has 1 year to maturity. The current coupon

has just been paid out. The current price of the bond is $1018.772.

• A zero coupon bond with a face value of $1,000 and 2 years to maturity. The

bond trades at $907.029.

• An annuity that pays $50 every year for the next 3 years. The next payment will

be a year from now and the last payment will be 3 years from now. The annuity

is currently worth $136.967.

All these securities are risk-free. Note that there is no direct borrowing and lending

here, so if you want to borrow (lend) you need to sell (buy) an appropriate bond.

If you want to borrow (lend) you need to sell (buy) an appropriate bond.

Bank of Montreal offers a forward rate over year 3, f3, of 3%. That rate is good

for a loan or deposit of $10,000. Can you make money and eat a free lunch at

Bank of Montreal’s expense? If so, how?

are paid out annually and the bond has 1 year to maturity. The current coupon

has just been paid out. The current price of the bond is $1018.772.

• A zero coupon bond with a face value of $1,000 and 2 years to maturity. The

bond trades at $907.029.

• An annuity that pays $50 every year for the next 3 years. The next payment will

be a year from now and the last payment will be 3 years from now. The annuity

is currently worth $136.967.

All these securities are risk-free. Note that there is no direct borrowing and lending

here, so if you want to borrow (lend) you need to sell (buy) an appropriate bond.

If you want to borrow (lend) you need to sell (buy) an appropriate bond.

Bank of Montreal offers a forward rate over year 3, f3, of 3%. That rate is good

for a loan or deposit of $10,000. Can you make money and eat a free lunch at

Bank of Montreal’s expense? If so, how?

Expert's answer

The one year spot rate r1: 1,08/(1+r1)= $1018.772/$1000=> r1=6,01%

The two year spot rate r2: 1/(1+r2) 2 =$907,209/$1000=> r2=3,11%

The two year spot rate r3: $50*(1+r3) 3 = $136.967=> r3=40%.

The two year spot rate r2: 1/(1+r2) 2 =$907,209/$1000=> r2=3,11%

The two year spot rate r3: $50*(1+r3) 3 = $136.967=> r3=40%.

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