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The market one-year, strip (zero) spot rate is 4
The market one-year, strip (zero) spot rate is 4.5%, and the forward rate from year one to year two (meaning for lending/borrowing money in a year for one more year) is 3.5%. Today, an individual is willing to lend or borrow money for two years at an annual rate of 4.6%. Is there an arbitrage opportunity? If yes describe it.
Expert Solution
Here in order to determine whether there is any arbitrage opportunity we first calculate the spot rate in year 2.
The forward rate after 1 year for 1 year should be equal to
= (1 + spot rate Year 2) ^2/ (1+Spot rate year 1) – 1
So, the spot rate for year 2 would be calculated as
((1 + 0.035) *(1 + 0.045))^(1/2) – 1
= 0.03998
Or = 4.00%
Now here there is an arbitrage opportunity because the spot rate for 2 year as calculated from the forward rate for 1 year after 1 year is 4.00% but the borrowing and lending in the market for 2 years is at 4.60% so here the arbitrage opportunity arises and investors can take the advantage by borrowing and investing.
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