Arizona State University FIN FIN MISC All the interest rates are per annum with continuously compounding….

Arizona State University FIN FIN MISC All the interest rates are per annum with continuously compounding….

All the interest rates are per annum with continuously compounding.

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Suppose that in the fixed-income securities market, the one-year, two-year, and three-year spot interest rates are 6.000%, 6.500%, and 7.000%, respectively. (That is, R0,1 = 6.000%, R0,2 = 6.500% , and R0,3 = 7.000%.) . In addition, in the forward interest rate market, the one-year forward rate two-years from now (F2,1) is 8.500%. (This is the only forward rate available in the market.)

What should be the arbitrager’s strategy at t = 0

S1) Enter into a forward rate agreement, whereby, you will _____ (Lend, Borrow or Do nothing) at one-year forward rate two years from now

S2) ________ (Lend, Borrow or Do nothing) at one year spot rate

S3) ________ (Lend, Borrow or Do nothing) at two year spot rate

S4) ________ (Lend, Borrow or Do nothing) at three year spot rate

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