The Following Information Relates to Questions 1-6
Katrina Black, Portfolio

question 12

Multiple Choice

The following information relates to Questions 1-6
katrina black, portfolio manager at Coral bond Management, ltd., is conducting a training session with alex Sun, a junior analyst in the fixed income department. black wants to ex-plain to Sun the arbitrage-free valuation framework used by the firm. black presents Sun with exhibit 1, showing a fictitious bond being traded on three exchanges, and asks Sun to identify the arbitrage opportunity of the bond. Sun agrees to ignore transaction costs in his analysis.exhibit 1 Three-Year, €100 par, 3.00% Coupon, annual-Pay option-Free bond
$\begin{array} { c c c c } & \text { Eurex } & \text { NYSE Euronext } & \text { Frankfurt } \\\hline \text { Price } & € 103.7956 & € 103.7815 & € 103.7565 \\\hline\end{array}$ black shows Sun some exhibits that were part of a recent presentation. exhibit 3 presents most of the data of a binomial lognormal interest rate tree fit to the yield curve shown in ex-hibit 2. exhibit 4 presents most of the data of the implied values for a four-year, option-free, annual-pay bond with a 2.5% coupon based on the information in exhibit 3.exhibit 2 Yield to Maturity Par rates for one-, two-, and Three-Year annual-Pay option-Free bonds
$\begin{array} { l c c } \text { One-Year } & \text { Two-Year } & \text { Three-Year } \\\hline 1.25 \% & 1.50 \% & 1.70 \% \\\hline\end{array}$ exhibit 3 binomial interest rate tree Fit to the Yield Curve (Volatility = 10%)
exhibit 4 implied Values (in euros) for a 2.5%, Four-Year, option-Free, annual-Pay bond based on exhibit 3
black asks about the missing data in exhibits 3 and 4 and directs Sun to complete the following tasks related to those exhibits:
task 1 test that the binomial interest tree has been properly calibrated to be arbitrage-free.
task 2 Develop a spreadsheet model to calculate pathwise valuations. to test the ac-curacy of the spreadsheet, use the data in exhibit 3 and calculate the value of the bond if it takes a path of lowest rates in Year 1 and Year 2 and the second lowest rate in Year 3.
task 3 identify a type of bond where the Monte Carlo calibration method should be used in place of the binomial interest rate method.
task 4 update exhibit 3 to reflect the current volatility, which is now 15%.
-a benefit of performing task 1 is that it:

• A) enables the model to price bonds with embedded options.
• B) identifies benchmark bonds that have been mispriced by the market.
• C) allows investors to realize arbitrage profits through stripping and reconstitution.

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