Additional info beneath table. Using the data presented below, create two synthetic bonds and determine their prices at both the bid and ask side of the market.

Hint: Write down the cash flows of the callable bond. You will need to buy enough of the non-callable coupon bond to match the coupon payments of the callable bond. Notice that you will have a cash flow shortfall for the final principal payment. This is where the purchase of zero-coupon bonds enters.

Treasury Bonds	Ask	Bid
8 May 00-05	101-8/32	101-4/32
12 May 05	129-29/32	129-23/32
8 7/8 May 00	104-16/32	104-12/32
Treasury Strips
May 00	46-21/32	46-08/32
May 05	30-10/32	29-29/32

On January 7, 1991, Samantha Thompsons attention was caught by the pricing of the 8 May 00-05, or the 8.25% coupon Treasury bond maturing May 15, 2005, first callable on May 15, 2000, whose price appeared out of line relative to other bonds in the market. By combining noncallable bonds maturing in 2005 with zero coupon Treasuries (or STRIPS) maturing in 2005, Ms. Thompson could create a synthetic bond with semiannual interest payments of $4.125 per $100 face value and whose final payment of $100 at maturity exactly matched those of the callable bondif the callable bond was not called. Because this synthetic bond did not surrender a redemption right to the government, it should be worth more to investors (i.e., have a higher price or a lower yield) than the callable bond of the same maturity.

Alternatively, Ms. Thompson could construct another synthetic noncallable Treasury bond by combining noncallable bonds maturing in 2000 with STRIPS maturing in 2000; this synthetic should also be worth more than the callable 00-05. This synthetic matched the callable bondif it was called at the first possible date. It too should be worth more than the callable bond. Based on the prices on January 7, 1991, these simple pricing relations seemed to be violated.