VRM9 - Pricing Conventions, Discounting, and Arbitrage

Question 1

Define the “law of one price”, explain it using an arbitrage argument, and describe how it can be applied to bond pricing

Answer 1

LOOP: if two portfolios provide the same future cashflows, they should sell for the same price

If they don’t, arbitrage opportunities exist. Short more expensive and lock in profit of cheaper, or immediately sell and obtain same cashflows for cheaper

Question 2

Identify the components of a US Treasury bond and compare the structure to Treasury STRIPS, including the difference between P-STRIPS and C-STRIPS

Answer 2

STRIPS are created by investment dealers when coupon bearing bond delivered to Treasury and exchanged for its principal and coupon components C is coupon, P is principal part

Question 3

Construct a replicating portfolio of multiple fixed income securities to match the cashflows of a given fixed income security

Answer 3

Take positions in securities that provide cash flows at the same time proportionally - start with longest maturity cashflows when replicating

Question 4

Differentiate between “clean” and “dirty” bond pricing and explain the implications of accrued interest with respect to bond pricing

Answer 4

Dirty = clean + accrued interest