Calculate the clean and dirty prices of the two bonds

Calculate the clean and dirty prices of the two bonds in Exhibit 1 at the existing yields on November4th, 2008. (Note from page 3 of the case that the 10.625% bond is yielding 3.61%, and the 4.25% bond isyielding 3.26%.)2. Explain the exact steps James Franey would take to put on the arbitrage trade.3. On November 4th, assume that James Franey buys 550,000 ($1,000 face value) of one of the bonds andshorts an equal dollar amount of the other bond. (Ignore the annual interest financing charge, 0.15%,and income, 0.10%.)

A] What investment is required from the hedge fund’s capital? (Assume a 2% haircut on the longposition and a 2% margin requirement on the short position.)

B] Assume that the yield on the 10.625% bond immediately converged to the current yield of the4.25% bond, how could he exit the trade and how much profit would he make? What is his returnon initial invested capital?

C] If the yield on the 10.625% bond increases or decreases by 1 basis point immediately after thetrade, how much would he lose or gain? What is the fund’s return on initial invested capital ineach case?

D] If the yield on the 10.625% bond increases by 30 basis points immediately after the trade, howmuch would he gain or lose? What is the fund’s return on initial invested capital? Would he haveto provide more capital, and if so why and how much?4. Is this trade eventually guaranteed to be profitable? What are the risks?