Financial Risk Manager (FRM), Topic 4: Valuation and Risk Models, Fixed Income, Bruce Tuckman Chapter 1, Prices Discount Factors and Arbitrage. How do we exploit the Law of One Price (which asserts that--absent confounding factors like liquidity or taxes--is only one set of discount factors)? We construct a replicating portfolio; i.e., a portfolio that produces the same stream of cash flows as the bond that is mis-priced. Then we purchase the bond/portfolio that is trading cheap and we sell (short) the bond that is trading expensive. In this example, net proceeds equal $0.065 which is only a few pennies. But leverage can increase the riskless profit to $325,000, wow!
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