Solutions to HBS Cases

(1) “Deutsche Bank: Finding Relative Value Trades”

(HBS 9-205-059)

(2) “COUGARs”(HBS 9-295-006)

– Case Studies –

Maastricht University
School of Business and Economics

Place: Maastricht, NL
Date: February 27th 2023
Names: Joe Moret (i6186285)
Oktürk Louis (i6195698)
Bernardo Soares (i6337350)
Thies de Koning (i6218276)
Study: MSc Financial Economics
Course: EBC4058 - Fixed Income
Management
Group: 03
Team: Subgroup A
Tutor: Ali Ebrahim Nejad

1
Table of Contents

1. Case - Deutsche Bank: Finding Relative Trade Values ……………………………….. 3

1.1 Introduction ………………………………………………..…………..…………………… 3
1.2 Question 1 ………………………………………………………..……..………………..… 3
1.3 Question 2 ………………………………………………….……………………..….…..… 4
1.4 Question 3 ……………………………………………………….…...…………………….. 6
1.5 Conclusion ………………………………………………………..………….……...……… 6

2. Case - COUGARs ………………………………………..……………………………. 7

2.1 Introduction ………………………………………………..………...…………………… 7
2.2 Question 1 ……………………………………..…………..…………………….…………. 7
2.3 Question 2 …………………………………………………..…….………….……………... 7
2.4 Question 3 ……………………...…………………………………………………………… 8
2.5 Question 4 ……………………..…………………………………………..………………... 9
2.6 Conclusion ……………………..……………………………………………………………. 9

3. Appendix …………………………………..…………………………………..……….. 11

4. References ……………………………………..……………………………………….. 16

2
 1. Case - Deutsche Bank: Finding Relative Trade Values

1.1 Introduction

With this case, we see how Deutsche Bank’s fixed-income research team functions and the services
they offer. Furthermore, we also go into the concept of relative-value trades and how the bank’s team
approaches this trading strategy to make a profit for their clients. To answer the case questions, we start
by explaining how the research team works; then, we go into the different trading strategies that can be
taken regarding the data given. We finish by pointing out the possible shortcomings of said approaches.

1.2 What is the role of the fixed-income research group that works within the
large financial institution Deutsche Bank?

Deutsche Bank as a group segregated its fixed-income operations into three distinct pillars: investor
coverage, issuer coverage, and research. This case focuses on the function and operations of Deutsche
Bank's Fixed Income Research division. The group is organised into two primary operations, the first
of which is strategic advice on macroeconomic trends and the second of which focuses on activities
with relative value.

Strategic advice on macroeconomic trends is difficult to monetise since it is primarily intended for
educational reasons and not for recommending particular trades that would make a profit. The group's
responsibility is to notify external clients of macroeconomic trends or projections that they anticipate.

The strategic guidance is based on long-term conversations with their external customers, which is
particularly attractive to clients with long-term obligations or assets, such as insurance companies,
pension funds, or institutions that must match their long-term commitments and assets. It is difficult
for the strategic advisory group to monetise their job, given that the advice and services they offer
customers are primarily intended to enhance its brand value, customer relationships, and market
perspectives.

The second department within the Fixed Income Research group oversees relative value activities.
Deutsche Bank's internal traders and external customers offer this service. The group is responsible
for discovering quickly profitable trading ideas. They examine various types of instruments and keep
a close eye on the fixed-income markets in terms of pricing, yields, and other variables that may
provide fresh trading possibilities.

According to the Chief of Relative Research for Europe, Jean Dumas, their goal is to "take items that
first don't appear connected and see whether a transaction can be made” (Chacko, Hecht, Dessain &
Sjoman, 2005). These fresh insights are released regularly for both internal and external traders and
customers. Comparing the prices of the securities already traded on the market to the prices the
organisation believes the securities should be traded for based on an internal model is one method for
determining relative-value trading.

The mission of the Fixed Income Research Group is to give information on macroeconomic trends
and to identify potentially successful trading techniques from huge market data. Moreover, the group
does specialised work for customers who require assistance assessing and counselling their clients'
balance sheets and asset-liability mismatches.

As previously stated, it is difficult to monetise the work of the Fixed Income Research Group; hence,
it is assessed based on three distinct criteria. The first consideration is the market's general direction,
i.e., whether or not the group could anticipate rate and spread movements. Second, the proportional
value of the deals that the group initiated, and third, the amount of new tailored business that was
produced from external customers.

3
1.3 What trading strategies (going long or short) would you recommend for
the various maturities depicted in Exhibit 4?

Exhibit 1 provides the current market prices of coupon-paying yields, which are then utilised to
calculate the implied yield and price of a bond with no coupon payments. It is required to determine
implied prices and yields since Deutsche Bank's forecasting model also computes the yields expected
for a zero-coupon yield of various bonds with varying maturities, as shown in Exhibit 4. In
accordance with Sundaresan’s (2009) Bootstrapping procedure, we calculated the implied Zero Prices
for various maturities by multiplying the Dirty Prices of the coupon-paying Bonds (from Exhibit 1)
with the Inversed Cash Flow Matrix. Subsequently, we plugged the Implied Zero Prices for each
maturity into the following formula from Sundaresan (2009) to receive the Annual Zero Coupon
Yield:

1
𝑍𝑒𝑟𝑜 𝐶𝑜𝑢𝑝𝑜𝑛 𝑃𝑟𝑖𝑐𝑒𝑠𝑇 = 2 ∗ [ 1 − 1]
𝐴𝑛𝑛𝑢𝑎𝑙 𝑍𝑒𝑟𝑜 𝐶𝑜𝑢𝑝𝑜𝑛 𝑌𝑖𝑒𝑙𝑑 𝑇

1
⟺ 𝐴𝑛𝑛𝑢𝑎𝑙 𝑍𝑒𝑟𝑜 𝐶𝑜𝑢𝑝𝑜𝑛 𝑌𝑖𝑒𝑙𝑑 𝑇 = 2 ∗ [ −1
𝑍𝑒𝑟𝑜 𝐶𝑜𝑢𝑝𝑜𝑛 𝑃𝑟𝑖𝑐𝑒𝑠1/𝑇

To develop profitable trading strategies for a long or short position for the various bonds, one must
compare the prices or yields predicted by the Deutsche Bank model with the zero-coupon prices and
yields suggested by the current market values of coupon bonds. Graph 1 depicts the bootstrapped spot
rate curve, which is the plot that shows the yields for zero-coupon bonds with various maturities. The
differences in the zero-coupon yields in basis points of the Market- and Deutsche Bank Models are
more comprehensively illustrated by Graph 2, showing mostly higher yields in the Market model than
for the Deutsche Bank model, except for maturities 2 and 50 in half-years.

Graph 1: Similar Term Structure given Zero-Coupon Yields

4
Graph 2: Basispoint Difference in Zero-Coupon Bond Yields for Market- and Deutsche Bank – Model

The mission of the fixed-income team is to spot exactly those arbitrage possibilities. Deutsche Bank
should buy the bonds in those maturities with a positive yield difference, meaning that the bond prices
are undervalued, and sell the bonds having negative yield differences because those securities are
relatively overvalued. Table 1 summarises our recommendations for Deutsche Bank’s optimal trading
strategy. For instance, the positive yield differences are marked with “Long”, while the bonds with
negative yield differences at maturities 2, 40 and 50 (in half years) should be shorted. It should be
noted that Deutsche Bank’s model is calibrated to match the market price of the two-year and ten-year
bonds. Thus the yields of both models exactly match.

Table 1: Recommendation of Trading Strategy based on Yield Differences in Models

5
1.4 Discuss possible shortcomings of this approach.

Traders use long and short trading approaches daily to make a profit. However, both of these approaches
have their risks.

Firstly, long positions can take time to make a profit and require patience to hold. Furthermore, money
spent on a long position is stopped and could be used to explore other market opportunities. Apart from
that, it is very likely that an investor with a long position will get his previous profits wiped out by a
sudden short-term drop, making all his previous effort useless.

Now on the short approach side, the worst possible shortcoming to consider is the possibility of losing
more money than the one that was invested because if a stock keeps going higher. The investor will
keep losing money until he closes that position. Another point to consider would be that with a short
position, the profit will always be limited because a stock’s price cannot fall lower than zero. Finally,
timing is also essential with a temporary position, as shorting too late or too soon can make an investor
lose money or pass up profit opportunities.

All in all, both approaches have their risks. While the long position approach has a lower risk but also
lower/slower reward, the short position strategy has the potential to make more money and more
quickly, but it also comes with the risks stated above.

1.5 Conclusion

Deutsche Bank’s Fixed Income Search Group mandate is to spot value propositions across bond and
derivative markets, besides providing strategic advice on macro trends for insurance companies. The
main goal of this paper was to find out the relative value trades, meaning that we had to compare the
yields of the zero-coupon bonds of the market model with the sophisticated model from Deutsche
Bank, which incorporates various assumptions about the speed of adjustment of short and long-run
rates, which were analogous for inflation and the output gap. As mentioned before, Deutsche Bank
should buy those bonds in which the difference in market yields and their model is positive as those
securities are undervalued given their mathematical formulas and vice versa.

6
 2. Case - COUGARs

2.1 Introduction

This case study explores COUGARs and whether investing in them would be worthwhile. The subject
is divided into four questions. The definition of COUGARs and a discussion of their parallels and
contrasts with U.S. Treasury Bonds open the first section. The second half of the article then examines
the benefits of choosing COUGARs over U.S. Treasury Bonds. Also, it covers the advantages and
disadvantages of purchasing COUGARs. The implied spot yields of U.S. Treasuries for all maturities
are then calculated in the third paragraph, which starts by first demonstrating how to do so. A few
exhibits will be displayed to support this. The paper's final section poses the question of whether
COUGARs are overpriced or underpriced, and it is answered with a mathematical calculation.

2.2 What are Cougars, and what is the difference from U.S. Treasury Bonds?

Investment banks developed COUGARs, or Certificates on Government Receipts, as a form of financial

security to compete with U.S. Treasury Bonds in the 1980s. These securities were set up as pass-through
trusts, giving trust shareholders all the tax and credit advantages of absolute U.S. Treasury ownership.
The trust issued liabilities that matched the payment stream that investors would receive on their
investments in U.S. Treasuries and retained only U.S. Treasuries as assets. The payment dates for the
trust's assets and liabilities were identical to eliminate any possibility of reinvestment.

Investment banks arranged for a custodian bank to handle the interest and principal payments from an
underlying U.S. Government bond to investors who got to pick and choose which payments they wanted
to receive. These investment banks were removing the payment stream from the underlying bond and
allowing investors to select the combination of prices that piqued their interest. By establishing a pass-
through trust, the stripping was carried out.

Although both fixed-income instruments backed by the U.S. government's credit, COUGARs and U.S.
Treasury Bonds had a lot in the joint, there were a few significant variations. The manner the payments
were set up was one of the main distinctions. Unlike COUGARs, which enabled investors to select the
specific payments they were interested in receiving, U.S. Treasury Bonds made interest and principal
payments according to a predetermined timetable. Investors that desired more significant control over
their cash flows found COUGARs appealing due to their flexibility.

The yield was another distinction between COUGARs and US Treasury Bonds. When comparing
similar-maturity COUGARs to U.S. Treasury Bonds, COUGARs often have a higher yield. Due to the
ability of the investment banks to separate the payment stream from the underlying bond and sell the
individual instalments to investors, a bespoke product with a higher yield was essentially created.

7
In order to match up with U.S. Government bonds, investment banks developed cougars as a kind of
financial security in the 1980s. They were set up as pass-through trusts, giving investors confidence in
all the tax and credit benefits of absolute U.S. Treasury ownership. The COUGARs’ greater yield and
flexible payment terms were their main benefits over the U.S. Government Bonds.

2.3 Why could it be interesting for an investor to hold a Cougar instead of a U.S. Treasury
bond of the same maturity?

Because of the way it is set up, a Cougar often has a greater yield than a Treasury bond. Because of the
possibility of a greater yield, investors may find it more appealing to own a Cougar than a U.S. Treasury
bond with the same maturity. In essence, a Cougar is a collection of customised cash flows that are
derived from an underlying U.S. Treasury bond. Investors can select the precise cash flows, such as
interest or principal payments, that suit their investment requirements and get paid directly for them.

Investors have greater flexibility in earning higher rates with Cougars than typical U.S. Government
bonds, as the customisable payment structure does not require a fixed payment schedule. This allows
investors to adapt their payment arrangements to benefit from increased interest rates. Cougars can also
be designed with various maturities, providing investors with more investment options. Additionally,
the absence of interest rate risk in Cougars makes them a favourable alternative to conventional bonds
since investors can adjust their payments to take advantage of higher yields in response to market
changes, which would explain why the demand for Cougars is high.

Investment in Cougars, however, carries some drawbacks as well. Investors may need help purchasing
or selling their investments due to the OTC market's lower degree of liquidity compared to the market
for conventional bonds. The underlying U.S. Treasury bond could default, putting investors at risk of
losing their principal. In conclusion, Cougars come with added risks even if they have the potential to
deliver higher rates and more flexibility than conventional U.S. Treasury bonds. Before purchasing
Cougars, investors should thoroughly assess their investment objectives and risk tolerance.

2.4 Calculate the implied spot yields of U.S. Treasuries for all maturities.

The implied yield of the bond is the minimum rate of return investors are expecting to receive if they
invested their money in a series of zero-coupon bonds with the same maturity as the underlying bond.
To calculate the implied yield and compare them with the actual yield to maturity given to us, we first
need to calculate the price of the bonds and their cash flows. Only then would we have the inputs
required to solve for the discount rate making the present value of the bond's cash flow equal to its
price? The implied yield of any asset is not constant, however, as it fluctuates depending on economic
conditions such as inflationary pressure or the central bank’s response regarding the economy's future.

By calculating the implied yields of the securities, we want to measure whether cougars are worth
investing in. Therefore, we want to better understand the risk by comparing the actual yield of cougars
with the yield of zero-coupon bonds at the same time as maturity. As described in Sundaresan (2005),
The bootstrapping procedure consists of the following steps:

8
Step 1: Calculate the dirty price and the cash flows. Note that we need to compute accrued interest for
each bond and add it to the clean price to get the dirty price. The accrued interests are a function of the
par value ($100), the days accrued (1), and the coupon payments. The dirty price of each security is
then obtained by adding the accrued interest on the settlement date to the asking price. The case
highlighted that the settlement date was one day after the bond issuance, hence November 16, 1983, in
this case.
Step 2: It is often the case that we might be confronted with situations in which the prices of coupon
bonds are available, but zero-coupon prices are challenging. So, it is necessary to estimate zero coupon
bond prices based on the costs of the coupon bonds. This procedure is known as bootstrapping. Such
estimates of zero coupon bond prices are known as implied zeroes since they are implied by coupon
bond prices (Sundaresan, 2005). Note that some of the data corresponding to bond maturities were
missing. Hence, the assumption was made that the T-1 value would take its place when a value was
missing. In that case, we do not end up with any missing value. One could argue that no securities were
issued on those dates, but we thought it was not a realistic assumption. With all the information
calculated, it is possible to determine the cash flow matrix of each maturity date. Exhibit 3 shows the
first part of the inverse of the cash-flow matrix. Each row corresponding to the maturity date contains
entries that tell us the number of coupon securities to be bought or sold to create a zero (Sundaresan,
2006) synthetically.

We then compared the implied zero spot rate with the actual yield of cougars from the case in Exhibit
4. The reasoning is the following: if the yield difference between cougars and the implied rate is
positive, the implied yield is lower than the cougar's yield offered by the investment bank, and the price
will likely increase, making the cougar underpriced. The opposite is true for negative differences
between cougars' and implied yields. For example, an investor wondering if a mix of zero-coupon bonds
could be beneficial after an increase or a decrease in yield has all the information needed in the exhibits.
Most securities are overpriced long-term (5 to 10 years after issuance). Of 40 securities, 22 cougars are
underpriced, with a higher concentration of underpriced securities in the short-term maturities.

2.5 Given the efficient and liquid market for U.S. Treasuries, how would you explain this
result (just speculating!)? Was the general issue of the Cougars underpriced or
overpriced? Please support your arguments with a numerical calculation (hint: compare
the overall revenues generated for the investment bank with what they need to pay to create
the structure – the information is given in the case, but you need to look carefully to find
it).

In order to determine whether the overall issue of cougars is underpriced or overpriced and if we want
to know whether to strip a bond or not, we need to compare the price of bonds issued in November 1983
and maturing on November 2003 to the present value of all the cash flows derived from cougars. The
case highlights that the cougars are being offered at a substantial discount and stripped from U.S.
treasury bonds, effectively allowing investors to get the combination of payments they were most
interested in by stripping a bond. Quote on the quote: “Certificates on Government Receipts, Series 1
(“COUGARs”) will evidence future ownership of future interest or principal payments on up to
$300,000,000 United States Treasury 11 7 / 8 Bonds due November 15, 2003 (the “Bonds”) to be held
by Manufacturers Hanover Trust Company, as Custodian, for the benefit of COUGAR owners”. This
effectively means that the principal amount is $100, and the rate of return is 11.75% (11% +7/8). With

9
this information coupled with the price as a % of the face amount given, In this case, we can calculate
the actual price of cougars with different maturities. Then, it is just a matter of comparing the SUM of
cougars' cash flows to the bond’s price issued in November 1983. Exhibit 5 demonstrates that the value
of the cougars is way higher than the bond’s price. The investment bank can effectively profit by buying
bonds, stripping them according to the needs of potential investors and selling them.

The bond price amounts to $99.28, whereas the SUM of the cougar's price discounted at the 8.11%
discount yield in the case amounts to $177.79. This result is surprising as we would have thought such
a gap would be impossible. However, it could make sense as the demand from investors to personalise
the stripping to their needs might increase the liquidity of these securities and prices. If the demand is
way higher than the supply, it would explain such a price gap. Furthermore, investment banks proposing
such investment opportunities must either offer a risk premium or insure the risk appropriately. If the
risks are adequately insured, it also pushes the demand to the upside.

2.6 Conclusion

To conclude the first two sections, COUGARs were created as a financial instrument to compete with
U.S. Government bonds and provide investors with a more flexible payment schedule and greater yield.
Investors can choose the specific cash flow, such as principle or interest payments, that meet their
investment needs and get paid for them immediately. Although this can result in higher rates and more
flexibility, it also carries additional dangers, such as the possibility of the underlying U.S. Treasury
bond defaulting and decreased liquidity in the OTC market. Investors should, however, carefully
consider their investment goals and risk tolerance before purchasing COUGARs.

The third section covers the calculation of US Treasury implied spot yields for all maturities. The least
rate of return that investors would anticipate if they invested in a string of zero-coupon bonds with the
same maturity as the underlying bond is known as the implied yield. The procedure for determining the
dirty price and cash flows, as well as for estimating the prices of zero-coupon bonds based on the prices
of coupon bonds, are described in this section. The yield of cougars with the same maturity is then
compared to the implied spot rate to assess if the cougar is overpriced or underpriced. The section
concludes that most short-term cougars are underpriced, while most long-term cougars are overpriced.

The final paragraph addresses the question of whether Cougars are overpriced or underpriced. It is
discovered that the value of Cougars is more than the price of the bond issued in November 1983 by
comparing the price of Cougars to the present value of their cash flows. The investment bank can profit
by purchasing bonds, removing their value, and then offering them to prospective buyers. The need
from investors to customise the stripping to their needs, which boosts the liquidity of these assets and
prices, can be used to explain this unexpected conclusion. Investment banks must also provide a risk
premium or adequately insure the risk, which may increase demand.

10
 3. Appendix

Exhibit 1: Dirty price, accrued interest

11
Exhibit 2: Cash flow matrix (Only the first dates as Matrix is too big to fit in)

12
Exhibit 3: Inverse matrix

13
Exhibit 4: Yield under/overvaluation (Undervalued = 0; Overvalued = 1)

14
Exhibit 5: Overall value

15
 4. References

Chacko, G., Hecht, P. A., Dessain, V., & Sjoman, A. (2005). Deutsche Bank: Finding Relative Value
Trades.

Sundaresan, S. (2009). Fixed income markets and their derivatives. Academic Press.

16