To understand how treasury spot rates are used to calculate the arbitrage-free value of the treasury security, we will take imaginary treasury spot rates (given in the third column of the Table No.6) to find the value of 7% 5-year treasury security. Sum of the present value (given in the last column of the Table No.1) is the arbitrage-free value for the 7% 5-year treasury security.
Table 1: Determination of the Arbitrage-Free Value of a 7% 5-Year Treasury Security
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(a)
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(b)
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(c)
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(d)
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(e)
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Period
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Years
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Cash Flow in Rs.
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Spot Rate in %
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PV in Rs.
|
|
1
|
0.5
|
3.5
|
2.7589
|
3.4524
|
|
2
|
1.0
|
3.5
|
3.0356
|
3.3961
|
|
3
|
1.5
|
3.5
|
3.2856
|
3.3330
|
|
4
|
2.0
|
3.5
|
3.5563
|
3.2617
|
|
5
|
2.5
|
3.5
|
3.8659
|
3.1805
|
|
6
|
3.0
|
3.5
|
4.1068
|
3.0982
|
|
7
|
3.5
|
3.5
|
4.3574
|
3.0099
|
|
8
|
4.0
|
3.5
|
4.6012
|
2.9177
|
|
9
|
4.5
|
3.5
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4.9812
|
2.8049
|
|
10
|
5.0
|
103.5
|
5.1225
|
80.3725
|
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Arbitrage-Free Value of a 7% 5-Year Treasury Security is =
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108.8268
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