1. How is the interest rate tree rendered arbitrage-free? 

Use this list of Treasury bond prices as of February 15, 2001 toanswer the following questions.

(a) Derive the 6-month, 1-year and 1.5-year discount factorsusing the 8s, 0s and 6s.

(b) What is the arbitrage-free price for the 10s given thediscount factors from (a).

(c) Compute the 6-month, 1-year and 1.5-year par yields.

(d) Based on the no-arbitrage principle, compute the forwardrates from 6 months to 1.5 years and 1 year to 1.5 years.

(e) Construct a synthetic forward loan from 6 months to 1.5years using the 8s and 0s. Solve for the positions in the bonds andverify that the loan rate equals the forward rate of the sameterm.

(f) Construct a synthetic forward loan from 1 year to 1.5 yearsusing the 8s, 0s and 6s. Solve for the positions in the bonds andverify that the loan rate equals the forward rate of the sameterm.

Given that governmental accounting for government entitiesinvolves federal and state grants or tax-exempt debt securities;the condition known as arbitrage may exist. Explain arbitrage andwhat can government entities do to remain in compliance with theIRS on the issue of arbitrage?

Your answer should follow the scoring guide and be at least 250words in length. Peer reviewed documents to support your opinionare welcomed.

2. “Arbitrage pricing theory is an extension of the capital asset pricing model”. Explain this statement.