Jorgen Welsher, CFA obtains the following quotes for zero coupon government bonds all with a par value of $100.
| Type of Price | Delivery (years) | Maturity (years) | Price |
|---|---|---|---|
| Spot | 0 | 3 | $91.51 |
| Forward | 2 | 3 | $94.55 |
| Spot | 0 | 2 | $92.45 |
Welsher can earn arbitrage profits by:
A)
buying the 2-year bond in the spot market, going long the forward contract and selling the 3-year bond in the spot market.
B)
selling the 2-year bond in the spot market, going short the forward contract and buying the 3-year bond in the spot market.
C)
buying the 2-year bond in the spot market, going short the forward contract and selling the 3-year bond in the spot market.
I got the correct answer but maybe it was coincidence? This is how I solved it.
If you buy/go long you get the appreciation from the purchase price up to par so:
Spot 2 year: ($100 - $92.45) = $7.55
Forward 3 year: ($100 - $94.55) = $5.45
Short Spot 3 year (you owe the difference: ($100 - $91.51) = $8.49
$7.55 + $5.45 - *$8.49 = $4.51 in arbitrage profit?