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A zero-coupon bond maturing two years from now has a yield to maturity of 8 percent (annual compounding). Another zero-coupon bond with the same maturity date has a yield to maturity of10 percent (annual compounding). Both bonds have a face value of $100.
a. What are the prices of the zero-coupon bonds?
b. Describe the cash flows to a long position in the 10 percent zero-coupon bond and a short position in the 8 percent zero-coupon bond.
c. Are the cash flows in part b indicative of arbitrage?
d. Suppose the 10 percent bond matured in 3 years rather than 2 years. Is there arbitrage now?
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