IAI Question Nov , 2020 - 6 (i) IAI Question : Calculate the 5-year zero rate with continuous compounding if a 3% coupon bond for similar term sells for Rs. 75 and a 6% coupon bond for similar term sells for Rs. 85. The face values of bonds are Rs. 100. IAI Solution We can take a long position in two 3% coupon bond and a short position in 6% coupon bond. [1] The cashflows would be: At the time of investment: 2 x 75 – 85 = 65 [0.5] After investment but before maturity: 0 [0.5] This is because, we would receive 6% coupon for our long position in two 3% coupon and we would pay 6% coupon for our short position in 6% coupon. [0.5] At maturity: 2 x 100 – 100 = 100 [0.5] That is, 65 today would become 100 in 5 years time. Setting this in equation, we get: 65 x exp (5R) = 100 [0.5] Or, R = 8.62% I am not quite clear what is the wrong with below calculation and why answer not matching with below method with IAI solution answer 85 = 6(1+i) ^-1 + 6(1+i) ^-2 + 6(1+i) ^-3 +6(1+i) ^-4 +106(1+i) ^-5............(equation 1) 75 = 3(1+i) ^-1 + 3(1+i) ^-2 + 3(1+i) ^-3 +3(1+i) ^-4 +103(1+i) ^-5............(equation 2) Equation (2) - Equation (1) , we have 10 = 3(1+i) ^-1 + 3(1+i) ^-2 + 3(1+i) ^-3 +3(1+i) ^-4 +3(1+i) ^-5 By using interpolation , i comes out to be 15.1 % (approx) which could be converted into compounded continuously .