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Suppose that at time 0 a bank is considering buying an illiquid 2-year zero-coupon bond...

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Finance

Suppose that at time 0 a bank is considering buying an illiquid 2-year zero-coupon bond at a price (2). The bank can fund this transaction by long or short positions in 6-month zero-coupon bond (0.5), 1- year zero-coupon bond (1), 4-year zero-coupon bond (4) or a combination of the these bonds. Assume that the zero-coupon yield are (0.5) = 1%, (1) = 2.8%, (4) = 4.8%. Estimate the value of the zero-coupon yield at (2) using an interpolation technique. How should the bank proceed given that it wants to have the total position on the bonds insensitive to 1st order and 2nd order change in the yield?

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