Callable Bond, Putable Bond and Arbitrage (20 points) (2020,2021 Midterm)

Consider hypothetical Callable bond (C) and Putable bond (P) of XYZ Corporation. All
bonds in this question are risk free.

Both bonds have 2 years to maturity, face values of $1000, and annual coupon rates of
10%. Coupons are paid annually. The callable bond (C) can be called at par, only at the
end of the first period (right after the coupon payment). Similarly, the putable bond (P)
can be put at par, only at the end of the first period (right after the coupon payment). The
callable bond and the putable bond are now traded at $970 and $1020, respectively.

The 1-year and 2-year T-strips both trade at a yield to maturity of 10% (Effective Annual
Yield).

Suppose you can buy and short sell (borrow and sell) C, P and T-strips without
transactions costs. You forecast that interest rate will change in the future – one year
from now, the yield to maturity on one year T-strips at that time will not be 10% for sure.

a) If the callable bond will never be called and putable bond never be put, what
should be their current prices? (5 points) Note that the assumption in part a) does NOT
carry over to part b).

b) Given your forecast, show that there is an arbitrage opportunity. (15 points)
a) Without the option features, both the callable and the puttable bond should be traded
at par since coupon rate is equal to the YTM.

(2 points for the reason, 3 points for the price, and total 5 points)

b) Consider a portfolio of the callable bond and the puttable bond. If the one-period
interest rate is above 10% at the end of period one, then the puttable bond will be put.
If the one-period interest rate is below 10% at the end of period one, then the callable
bond will be called. In both cases, the portfolio cash flow will be 1200 at the end of the
period one and 1100 at the end of period two. Given a flat yield curve at 10%, the
portfolio value should be: 1200/1.1 + 1100/1.1^2 = 2000. However, the portfolio is
currently traded at 970+1020=1990, therefore it is underpriced. One strategy to
implement the idea: Buy Low Sell High as usual.

T=0 T=1 T=2

Buy callable bond and puttable bond -1990 +1200 +1100
Sell 120% of 1-year zero +1090.91 -1200 -
Sell 110% of 2-year zero +909.09 - -1100
Net cash flow +10 0 0
Cum. cash flow +10 +10 +10
(5 points for including both callable and puttable bond, 2 points for both selling 1-year zero and 2-year
zero, 3 points for selling correct amount, 5 points for the NCF and Cum. CF)