A bond dealer determines that the present value of a particular Treasury note based on Treasury spot rates is greater than its market price. The dealer can generate an arbitrage profit (assuming no transactions costs) by:
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A. B. C.A
To determine the correct answer, let's understand the situation described in the question and the concept of arbitrage.
Arbitrage is the practice of taking advantage of price differences in different markets to make a risk-free profit. In this case, the bond dealer has determined that the present value of a particular Treasury note, based on Treasury spot rates, is greater than its market price. This implies that the Treasury note is undervalued in the market.
Now let's analyze each answer choice:
A. Buying the Treasury note and selling its cash flows as Treasury STRIPS: Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities) are zero-coupon bonds that represent the separate cash flows of a Treasury security. By buying the Treasury note and selling its cash flows as STRIPS, the bond dealer is effectively separating the interest and principal payments and selling them as individual securities. However, this strategy does not exploit the price difference between the present value and market price of the Treasury note.
B. Buying the equivalent Treasury STRIPS and selling them as a Treasury note: This option suggests buying Treasury STRIPS and bundling them together to create a Treasury note. While this strategy allows the dealer to create a synthetic Treasury note, it does not take advantage of the undervaluation of the original Treasury note. Therefore, it does not generate an arbitrage profit.
C. Buying the undervalued note and selling short the Treasury security with the nearest maturity: This option involves buying the undervalued Treasury note and simultaneously selling short (borrowing and selling) a Treasury security with the nearest maturity. By doing so, the dealer is taking advantage of the price difference between the undervalued note and the Treasury security with the nearest maturity. This strategy aims to profit from the convergence of prices as the undervalued note's price increases and the shorted security's price decreases.
Based on the explanations above, the correct answer is C. Buying the undervalued note and selling short the Treasury security with the nearest maturity. This strategy allows the bond dealer to exploit the price difference and generate an arbitrage profit.