Betty Tatton is a fixed income analyst with the hedge fund Sailboat Asset Management (SAM). SAM...

  

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Betty Tatton is a fixed income analyst with the hedge fund Sailboat Asset Management (SAM). SAM invests in a variety of global fixed-income strategies, including fixed- income arbitrage. Tatton is responsible for pricing individual investments and ana- lyzing market data to assess the opportunity for arbitrage. She uses two methods to value bonds: Method 1 Method 2 Build and use a binomial interest rate tree. Tatton compiles pricing data for a list of annual pay bonds (Exhibit 1). Each of the bonds will mature in two years, and Tatton considers the bonds as being risk-free; both the one-year and two-year benchmark spot rates are 2%. Tatton calculates the arbitrage-free prices and identifies an arbitrage opportunity to recommend to her team. Discount each year's cash flow separately using the appropriate interest rate curve. Exhibit 1 Market Data for Selected Bonds Asset Coupon Bond A 196 Bond B 3% Bond C 5% Next, Tatton uses the benchmark yield curve provided in Exhibit 2 to consider arbitrage opportunities of both option-free corporate bonds and corporate bonds with embedded options. The benchmark bonds in Exhibit 2 pay coupons annually, and the bonds are priced at par. Exhibit 2 Benchmark Par Curve Maturity (years) 1 2 3 Market Price 98.0584 100.9641 105.8247 Hutto-Barkley Inc. Luna y Estrellas Intl. Peaton Scorpio Motors Yield to Maturity (YTM) Tatton then identifies three mispriced three-year annual-pay bonds and compiles data on the bonds (see Exhibit 3). Exhibit 3 Market Data of Annual-Pay Corporate Bonds Company 3% 0% 0% 3.0% 4.0% 5.0% Coupon Market Price Yield Embedded Option? 94.9984 88.8996 83.9619 5.6% 4.0% 6.0% No Yes No Lastly, Tatton identifies two mispriced Swiss bonds, Bond X, a three-year bond, and Bond Y, a five-year bond. Both are annual-pay bonds with a coupon rate of 6%. To calculate the bonds' values, Tatton devises the first three years of the interest rate lognormal tree presented in Exhibit 4 using historical interest rate volatility data. Tatton considers how this data would change if implied volatility, which is higher than historical volatility, were used instead. Exhibit 4 Interest Rate Tree; Forward Rates Based on Swiss Market Time 0 Time 1 Time 2 1% 2% 6% 5% 3% Q1) Based on Exhibit 1, which of the following bonds most likely includes an arbitrage opportunity? Q2) Based on Exhibits 2 and 3 and using Method 1, the amount (in absolute terms) by which the Hutto- Barkley corporate bond is mispriced is closest to: Q3) Method I would most likely not be an appropriate valuation technique for the bond issued by: Betty Tatton is a fixed income analyst with the hedge fund Sailboat Asset Management (SAM). SAM invests in a variety of global fixed-income strategies, including fixed- income arbitrage. Tatton is responsible for pricing individual investments and ana- lyzing market data to assess the opportunity for arbitrage. She uses two methods to value bonds: Method 1 Method 2 Build and use a binomial interest rate tree. Tatton compiles pricing data for a list of annual pay bonds (Exhibit 1). Each of the bonds will mature in two years, and Tatton considers the bonds as being risk-free; both the one-year and two-year benchmark spot rates are 2%. Tatton calculates the arbitrage-free prices and identifies an arbitrage opportunity to recommend to her team. Discount each year's cash flow separately using the appropriate interest rate curve. Exhibit 1 Market Data for Selected Bonds Asset Coupon Bond A 196 Bond B 3% Bond C 5% Next, Tatton uses the benchmark yield curve provided in Exhibit 2 to consider arbitrage opportunities of both option-free corporate bonds and corporate bonds with embedded options. The benchmark bonds in Exhibit 2 pay coupons annually, and the bonds are priced at par. Exhibit 2 Benchmark Par Curve Maturity (years) 1 2 3 Market Price 98.0584 100.9641 105.8247 Hutto-Barkley Inc. Luna y Estrellas Intl. Peaton Scorpio Motors Yield to Maturity (YTM) Tatton then identifies three mispriced three-year annual-pay bonds and compiles data on the bonds (see Exhibit 3). Exhibit 3 Market Data of Annual-Pay Corporate Bonds Company 3% 0% 0% 3.0% 4.0% 5.0% Coupon Market Price Yield Embedded Option? 94.9984 88.8996 83.9619 5.6% 4.0% 6.0% No Yes No Lastly, Tatton identifies two mispriced Swiss bonds, Bond X, a three-year bond, and Bond Y, a five-year bond. Both are annual-pay bonds with a coupon rate of 6%. To calculate the bonds' values, Tatton devises the first three years of the interest rate lognormal tree presented in Exhibit 4 using historical interest rate volatility data. Tatton considers how this data would change if implied volatility, which is higher than historical volatility, were used instead. Exhibit 4 Interest Rate Tree; Forward Rates Based on Swiss Market Time 0 Time 1 Time 2 1% 2% 6% 5% 3% Q1) Based on Exhibit 1, which of the following bonds most likely includes an arbitrage opportunity? Q2) Based on Exhibits 2 and 3 and using Method 1, the amount (in absolute terms) by which the Hutto- Barkley corporate bond is mispriced is closest to: Q3) Method I would most likely not be an appropriate valuation technique for the bond issued by:

Answer rating: 100% (QA)

1 Bond B 2 051... View the full answer