RSM332H1 Lecture Notes - Lecture 4: Trading Strategy, Interest Rate Risk, Arbitrage
Document Summary
Return earned on asset during period it was held. If you hold bond to maturity, you are hedged against interest rate risk. Government bond is not risk free if sold before maturity. Takes advantage of different prices in different markets. Price using existing assets with same cash flows. In equilibrium, price of asset = pv of cash flows. Any two portfolios composed of different assets with same cash flows at same time should have same price. Right hand sides of pv equation are equal. Build trading strategy with positive risk free cash flow without initial investment. Replicating portfolio: pay for in 1 year. sell by borrowing and paying in 1 year. Positive cash flow without putting any investment in. Net cash flow must be positive or zero. If negative, is not risk free because you have to pay at some point. Replicate 3-year bond with annual coupon of 5%, principal of with following assets:
