Explanation

Correct Answer: A

Spot curve (also known as the zero-coupon yield curve) is used for arbitrage-free valuation because:

1. Each cash flow is discounted at its own appropriate rate: The spot rate for each maturity period reflects the time value of money for that specific time horizon

2. Eliminates arbitrage opportunities: Using a single yield-to-maturity would create pricing inconsistencies, as different cash flows have different risk characteristics

3. Proper risk assessment: Corporate bonds require adding appropriate credit spreads to government spot rates to account for default risk

The arbitrage-free valuation process:

• Start with the government spot curve
• Add appropriate credit spreads for the corporate bond's rating and maturity
• Discount each cash flow using the corresponding spot rate plus credit spread
• Sum the present values to get the bond's fair value

This approach ensures that bonds with the same risk characteristics but different cash flow patterns are priced consistently.