Finance Question (Bond & Risk)
Consider Bond A, a 5-year, 10% coupon bond issued by the Government with a face value of $1,000. Assume the required return for Bond A is 9%. Assume some investors prefer zero coupon bonds and are willing to accept lower required return of 8%.
1. Can you issue 1-year, 2-year, 3-year, 4-year and 5-year zero coupon bonds on the basis of one Bond A?
2. Can you make a profit out of this operation?
3. Would there be any risks?
- joeLv 41 decade agoFavorite Answer
Government bonds= Treasury
1. No, the investment periods is fixed by gov treasuries, not by investors
2. Yes there is opportunity for profit, also know as arbitrage opportunity, as follows:
You can buy 5 year treasury with YTM of 9% at present value of
Sell to investors at YTM of 8% at present value of $463.19
Realistically this doesnt happen in normal market conditions, as the opportunity will disappear very quickly, with buyers/sellers trading until there is no profit to be had, then the marker will adjust back to equilibrium
3. Treasury is credit risk free, in other words debt owed by US gov. guarantees to pay you back your original principle plus extras as interest. (your scenario of 9% is very unlikely for a T-bill. Private institutions may be)
In terms of the arbitrage opportunity, there is no risk, because essentially you are buying bonds at cheaper prices and selling high.
Also liquidty is not much of an issue with T-bills, as you will definitely be able to sell or get rid of the bonds on the market