Asset Pricing

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1 Trading Suppose you are a sophisticated investor trading in the bond market. Firm Alpha has issued Bond A which you believe is currently overpriced. You expect that the price of A will fall during the current trading day. At present you do not own any bonds yourself but you can borrow, buy and sell bonds through your broker (assume that there is no borrowing fee).
(a) In the morning Bond A is traded at £100. You would like to act on your belief that the price of A will fall. Describe your trading strategy. What will be your actions in the morning to initiate this strategy and the associated cash flows? Provide details and reasoning behind your current actions (the word limit is 150 words). [6 Marks]
(b) Describe your resulting portfolio in terms of long and short positions after you have initiated your trading strategy from (a). Give full details and an economic interpretation of all your entitlements and obligations in no more than 100 words. [6 Marks]
(c) Suppose that your prediction was wrong and that in the afternoon the price of Bond A has increased by 2% from £100. Suppose that tomorrow the bond A will pay an annual coupon (£5 per bond) to the bond holders. If you want to maintain the trading position tomorrow to wait for the possible price drop, what will be your resulting cash flows tomorrow? [4 Marks]
2 Pricing by replication Suppose there are 3 fixed-income securities: X, Y, and Z. Security X is a 2-year coupon bond, maturing at date 2 with a face value of £100 and coupon rate of 5 % (coupon payments occur at date 1 and date 2). Security Y is a 1-year bond paying £20 at date 1. Security Z pays 30 at date 1 and 210 at date 2. Prices are pa=£95, pb=£18 and pc=£220.
(a) Determine the rank of this market. Is this market complete? Provide full details. The word limit for part (a) is 100 words (excluding formal expressions). [7 Marks]
(b) Determine (using replication) if security Z is priced correctly relative to X and Y. Provide full details. Indicate if Z should be bought or sold and explain why (no more than 50 words). [7 Marks]
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