The next section develops the theory and some general

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: zero coupon bond? Answer Buy 2 Bond A and Sell 1 Bond B. Corporate Finance, Tri Vi Dang, Columbia University, Fall 2013 43 Portfolio Payoff 1=1 t=2 Buy 2 Bond A 20 220 Sell 1 Bond B -20 -120 Portfolio 0 100 The portfolio is a zero coupon bond. Corporate Finance, Tri Vi Dang, Columbia University, Fall 2013 44 Bond arbitrage t=1 t=2 Price (t=0) YTM Bond A 10 110 91.74 10% Bond B 20 120 98.54 14% Implication Bond B has a higher return than Bond A (and thus a relatively lower price). Bond B is better. Corporate Finance, Tri Vi Dang, Columbia University, Fall 2013 45 Arbitrage strategy (Example) Sell 100 Bond A, you receive: 9174.00 Use this money to buy 93 Bond B: 9164.22 (=93*98.54) Net: +9.78 Payoff of this strategy Bond A -1000 -11000 Bond B 1860 11160 Net +860 +160 Corporate Finance, Tri Vi Dang, Columbia University, Fall 2013 46 Implication By (short) selling the relatively overpriced Bond A and buying the underpriced Bond B in that way, you obtain t=0 $9.78 t=1 $860.00 t=2 $160.00 without using any own money. Corporate Finance, Tri Vi Dang, Columbia University, Fall 2013 47 Remark The next section will develop a general framework (and simple technique) of - how to strip bonds - how to identify a bond arbitrage opportunity - how to construct trading strategies to exploit it for any maturity structure and an arbitrary large set of tradable bonds. Remark Fixed income arbitrage hedge funds are doing similar things. Corporate Finance, Tri Vi Dang, Columbia University, Fall 2013 48 Relevant Reading Textbook Chapter 4, 5 and 8 Corporate Finance, Tri Vi Dang, Columbia University, Fall 2013 49...
View Full Document

This document was uploaded on 02/16/2014 for the course ECON w4280 at Columbia.

Ask a homework question - tutors are online