Zero-coupon rate curve and expectations. The short-term zero-coupon rate curve of the euro zone is given as:

The current refinancing rate of the European Central Bank (ECB) is at 2.75%. This is the rate at which banks can borrow from the ECB for 2 weeks. The ECB Board of Governors will meet in 2 weeks and potentially decide on a new refinancing rate R.

(a) Without making any calculation can you guess if the market expects the ECB to:

(i) Lower its rate by 25 bps (i.e. R = 2.5%)?

(ii) Leave its rate unchanged (i.e. R = 2.75%)?

(iii) Raise its rate by 25 bps (i.e. R = 3%)?

(iv) Raise its rate by 50 bps (i.e. R = 3.25%)?

(v) Any other scenario?

(b) The treasury department at Lezard Brothers, a reputed investment bank, must find €100mn in cash for the coming month. Find two ways to achieve this objective. What are the corresponding borrowing costs?

(d) Fadeberg News, a financial news agency, recently published the following survey of the predictions from leading financial economists at top investment banks:

Based on this survey, Bernard Bull, a trader at Lezard Brothers, thinks that the 1-month zerocoupon rate of 2.92% is overvalued and comes to you, the head of trading at Lezard Brothers, with the following strategy:

• Invest €100mn at 2.92% over one month;

• Borrow €100mn at 2.75% for 2 weeks;

• In 2 weeks, roll over and borrow €100mn at rate R for 2 weeks.

(i) Bernard says his strategy is a “fantastic arbitrage opportunity.” Do you agree?

(ii) Calculate the profit or loss of this strategy in each of the scenarios in the survey.

(iii) Do you give a thumbs up to Bernard? There is no unique answer to this question.

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