FRM Part II · FRM Exam Part II · Arbitrage Pricing with Term Structure Models
A desk observes that a traded structured note is priced at 102.0, while the cost of a portfolio of zero-coupon bonds and cash that exactly replicates its cash flows in every state is 100.0. Transaction costs are negligible and the position can be held to maturity. Which strategy captures a riskless profit?
Sell the overpriced structured note and buy the replicating portfolio. The portfolio's payoffs match the note's in every state, so the position is hedged and the 2.0 price difference is a riskless profit. Buying the note or selling it unhedged is not an arbitrage.
- ASell the structured note and buy the replicating portfolio, locking in 2.0 with no net exposure at maturityCorrect
- BBuy the structured note and sell the replicating portfolio, locking in 2.0 with no net exposure at maturity
- CBuy both the structured note and the replicating portfolio to benefit from the higher expected return
- DSell the structured note only, and wait for its price to converge to 100.0
Explanation
The note is overpriced relative to the portfolio with identical payoffs. Selling the note at 102.0 and buying the replicating portfolio for 100.0 gives 2.0 today, and the portfolio's cash flows exactly offset what is owed on the note in every state. Buying the note would reverse the trade and lock in a loss. Selling the note alone leaves market risk.
Did you get it right without looking?
One question tells you little. A timed set on Arbitrage Pricing with Term Structure Models shows your real accuracy, how long you take and where you lose marks.
More Arbitrage Pricing with Term Structure Models questions
- Use the tree where the annual short rate is 4% today and moves to 8% or 2% after one year, with risk-neutral probabilities of 50% each. A Eu…
- A risk analyst compares the Vasicek model with the Cox-Ingersoll-Ross (CIR) model, where dr = k(θ - r)dt + σ√r dw. Which statement best desc…
- A short-rate model is dr = λ(t)dt + σe^(-αt)dw with σ = 1.00% per year and α = 0.50. The rate shocks accumulate over time, and the drift is …
- A trader replicates a one-period bond option using a bond and cash in a binomial tree. The replicating portfolio costs 2.40, while the optio…
- In a one-period binomial interest rate tree, a risk analyst states that the risk-neutral probability of an up move is 0.5 although the true …
- The current one-year rate is 5%. In one year the one-year rate will be 6% (up) or 4% (down), each with risk-neutral probability 0.5. A Europ…