The market one-year, strip (zero) spot rate is 4

Finance Dec 22, 2020

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

Yes, arbitraging is possible in this scenario because we are having a individual who is willing to lend at a lower rate and we will be borrowing from him at 4.6 % for 1 year.

We will be investing that money into one year strips spot rate and we will be earning the rate of return as follows-

= (Spot rate)(1+rate of return)-1)

= (4.5(1+.035)=4.6575%

The overall rate of return which will be made after investment= (4.6575-4.6)= .0575% per month.

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