Assume that the continuously compounded zeros rates for T=1, 2, 3, 4 (years) are 4.5%, 5.2%, 5.7%,...

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Finance

Assume that the continuously compounded zeros rates for T=1, 2,3, 4 (years) are 4.5%, 5.2%,
5.7%, 6.3% respectively. A market maker offers, through forwardrate agreements (FRAs), the
following rates; 6.078% for the period between the 1st and the 2ndyear, 6.900% for the period
between 2nd and the 3rd year and finally 8.300% for the periodbetween the 3rd and the 4th year.
Evaluate if arbitrage opportunities exist. If such opportunitiesexist, design a strategy that can
deliver the maximum profit on a principal of £100 million. Assumeannual compounding for the
FRA’s interest rate quotes.

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4.2 Ratings (873 Votes)

Time Zero Period No arbitrage implied forward rate between the period FRA offered in the market Arbitrage 1 450 2 520 1 to 2 6078 6078 No 3 570 2 to 3 6930 6900 Yes 4 630 3 to 4 8437 8300 Yes No See Answer

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Assume that the continuously compounded zeros rates for T=1, 2,3, 4 (years) are 4.5%, 5.2%,5.7%, 6.3% respectively. A market maker offers, through forwardrate agreements (FRAs), thefollowing rates; 6.078% for the period between the 1st and the 2ndyear, 6.900% for the periodbetween 2nd and the 3rd year and finally 8.300% for the periodbetween the 3rd and the 4th year.Evaluate if arbitrage opportunities exist. If such opportunitiesexist, design a strategy that candeliver the maximum profit on a principal of £100 million. Assumeannual compounding for theFRA’s interest rate quotes.