The Price Arbitrage Method

This is a method that is an alternative to the boot strapping method that has been discussed for deriving spot rates in the bond market.

This has the benefit of allowing spot rates for say a ten year period to be derived directly without having to work out for every year period from a balanced portfolio as in the boot strapping method.

All we need here is a portfolio of bonds which are to some extent in short position form, and also in the form of a long position.

This creates a zero coupon, effectively, at the appropriate maturity time, so you need two bonds of the same maturity but with different coupons, as should be evident and clear by now.

As a concrete example, then, you can derive the spot rate (three year) from the following: a three year 10% and a three year 5% bond.

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