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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
(a)
(b)
(c)
(d)
(e)
Period
Years
Cash Flow in Rs.
Spot Rate in %
PV in Rs.
1
0.5
3.5
2.7589
3.4524
2
1.0
3.0356
3.3961
3
1.5
3.2856
3.3330
4
2.0
3.5563
3.2617
5
2.5
3.8659
3.1805
6
3.0
4.1068
3.0982
7
4.3574
3.0099
8
4.0
4.6012
2.9177
9
4.5
4.9812
2.8049
10
5.0
103.5
5.1225
80.3725
Arbitrage-Free Value of a 7% 5-Year Treasury Security is =
108.8268
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