Professional Documents
Culture Documents
Introduction to the
Valuation of Fixed Income Instruments
• Absolute Pricing
– Dirty price and clean price*
• Relative Pricing
– Law of One Price
– No-arbitrage Pricing*
C C C+F
tp = + +...+
y y y
(1 + ) w (1 + ) 1+ w (1 + ) n −1+ w
2 2 2
tp = Dirty price
C C
C = semiannual coupon payment
0 w 1+w
y = the BEY
F = face value
Actual/365 AI = C x days/365
Actual/360 AI = C x days/360
Actual/actual AI = C x days/actual days in the year
30/360 All months are assumed to have 30 days (e.g. there are
30 days between Feb. 9 and Mar. 9). If the first date is on
the 31st change it to the 30th. If the 2nd date falls on the
31st and the first date is on the 30th or 31st, change the
2nd date to the 30th.
30E/360 Like 30/360 except that if the 2nd date is on the 31st it is
always changed to the 30th.
(a) $106.125
(b) $108.535
(c) $108.875
(d) $109.825
Can you reproduce the Asked Yield given the other information?
Hint:
1. Assume a par value $100 for convenience of calculation
2. The settlement date is the next business date: 10/1/2015
3. The asked yield is the yield-to-maturity implied by the asked (invoice) price in
%, or 0.57%
IRR=BEY 0.57%
Payment Date 10/1/2015 11/30/2015 5/31/2016 11/30/2016 5/31/2017
Cash Flow -104.5336 1.375 1.375 1.375 101.375
Time in 6m Units 0 0.328 1.333 2.328 3.333
Discount Factor 1 0.999 0.996 0.993 0.991
PV -104.5336 1.374 1.370 1.366 100.424
Sum of PVs (0.00)
Bond Prices
105.0000
Increase because closer
104.0000 to coupon payment
103.0000
102.0000
Flat Price
101.0000
Invoice Price
100.0000
99.0000
98.0000
97.0000
10/15/2000
12/15/2000
4/15/2000
6/15/2000
8/15/2000
2/15/2001
C1 C2 C3 CT −1 CT
P= + + + + T −1
+
1 + r1 (1 + r2 ) 2
(1 + r3 ) 3
(1 + rT −1 ) (1 + rT )T
T
Ct
=
t =1 (1 + rt )
t
C C C + Par
P= + +
1 + r1 (1 + r2 ) 2 (1 + r3 )3
50 50 50 + 1000
= + + = 974.14
1 + 5% (1 + 5.5%) 2
(1 + 6%) 3
• Strategy 1:
Points in Time 0 1 2
Buy 1 G - $90.00 + $4.00 + $104.00
Short 1 H + $94.50 -$6.25 -$106.25
• Arbitrage Profit?
• Strategy 2:
Points in Time 0 1 2
Buy 102.16% G - $91.94 + $4.0865 + $106.25
• Absolute Pricing
– Strong assumption: exact cash flows and discount rate
– Strong result: THE true price
• No-Arbitrage
– Weak assumption: no-arbitrage holds
– Weak result: relationship (restrictions) among prices
• Can be boundaries
• Can be wrong if prices are wrong in a systematic way
– Violation: arbitrage opportunities
• Sufficient condition for suboptimal portfolio
• Maybe many ways
• Not necessarily the best strategy
FINA 6152 - Fixed Income 35
Arbitrage?
• Limits to Arbitrage
– Transaction cost
– Restrictions on short-selling
• Collateral is required and may be forced to liquidate the
position if large losses occur
– Different securities may have slight differences in risks
• ‘Near’ arbitrage opportunities
• 2008 Earthquake
• Aftermath
– JM started another hedge fund just a year later
– Merton and Scholes returned to teaching
– The consortium recover their investment completely
• Outline
– Background (LBO and Junk Bond)
– Understand the securities involved
– Theoretical no-arbitrage pricing restriction
– Arbitrage strategy
– What happened?
Robert M. Dammon
Kenneth B. Dunn
Chester S. Spatt
• The bonds are usually not investment grade and are referred
to as junk bonds (High-yield bonds).
• RJR Nabisco
– an American conglomerate formed in 1985 by the
merger of Nabisco Brands and R.J. Reynolds Industries
– was purchased in 1989 by Kolberg Kravis Roberts
(KKR) in the largest leveraged buyout (LBO) (before
2005)
– Depending on the source cited, KKR paid between $25
billion and $31 billion for the acquisition
– The LBO was featured in a book and a movie called
“Barbarians at the Gate”
FINA 6152 - Fixed Income 58
RJR Nabisco Bonds
• In May 1989, RJR issued three nearly identical debt
securities maturing in May 2001 to finance the
leveraged buyout
– Cash-Paying Bond [Cash Bond]
• Pays semi-annual cash 13.5% coupon
– Pay-in-Kind (PIK) Bond [PIK Bond]
• Pays semi-annual 15% coupon in cash or additional PIK bonds (at the
option of RJR) through May 15, 1994
• Pays semi-annual cash 15% coupon after May 15, 1994
• Additional PIK bonds issued in lieu of cash are valued at their face value
– Deferred-Coupon Bond [Deferred Bond]
• No coupons are paid through May 15, 1994
• Pays semi-annual cash 15% coupon after May 15, 1994
FINA 6152 - Fixed Income 59
FINA 6152 - Fixed Income 60
RJR Nabisco Bonds
• Bonds Standings
– All three bonds have equal standing per dollar of claim in the event of
bankruptcy or default
• Sinking Fund
– 25% of the original principal amount to be retired on May 15, 1999 and another
25% on May 15, 2000
c
Cash Bond
3
1
d 2 p
Deferred Bond PIK Bond
• Cash flows of (2) are larger and less risky than those of (1)
• Some mis-pricing
p p
+ w m
vtc t t
n
+ 6.75 qit
(1.075) i =1
i =1 k =i +1
m
vt
c
n
+ 6.75 qit (3)
(1.075) i =1
• Large mis-pricing
• Difficult in Short-Sale?
– Doesn’t explain why someone will buy Cash Bond at
such a high price
• Tax?
– Explain at most 25% of the arbitrage profit
• Liquidity?
– No, the PIK and Deferred Bond are actually more liquid