c 2007 by Michael R.

Gibbons
Copyright 

Adventures in Debentures

Solutions to
Bond Valuation Using Synthetics
1.
Part a. For time period 0.0, the value of this constant coupon bond is:
10,000.03 = (1009.09

20


etr t ) + 9363.03e20.099444

t=1

For time period 0.5, the value of this constant coupon bond is:
10,496.43 = (1009.09

20


e(t.5)r t.5 ) + 9363.03e19.5.099297

t=1

For time period 1.0, the value of this constant coupon bond is:
10,004.32 = (1009.09

19


etr t ) + 9363.03e19.099132

t=1

Part b. For time period 0.0, the value of this constant coupon bond is:
10,964.66 = (1009.09

20


etr t ) + 9363.03e20.089444

t=1

For time period 0.5, the value of this constant coupon bond is:
11,454.33 = (1009.09

20


e(t.5)r t.5 ) + 9363.03e19.5.089297

t=1

For time period 1.0, the value of this constant coupon bond is:
10,952.61 = (1009.09

19


etr t ) + 9363.03e19.089132

t=1

Chapter 31: Solutions To Questions, Bond Valuation Using Synthetics

Page 1419

Adventures in Debentures

Part c. For time period 0.0, the value of this constant coupon bond is:

9,158.04 = (1009.09

20


etr t ) + 9363.03e20.109444

t=1

For time period 0.5, the value of this constant coupon bond is:

9,658.51 = (1009.09

20


e(t.5)r t.5 ) + 9363.03e19.5.109297

t=1

For time period 1.0, the value of this constant coupon bond is:

9,173.27 = (1009.09

19


etr t ) + 9363.03e19.109132

t=1

Part d.

Passage of Time (in Years)

0.0

0.5

1.0

7.00%

$10,964.66

$11,454.33

$10,952.61

8.00%

$10,000.03

$10,496.43

$10,004.32

9.00%

$9,158.04

$9,658.51

$9,173.27

Short-Term Rate:

Chapter 31: Solutions To Questions, Bond Valuation Using Synthetics

Page 1420

Adventures in Debentures

Performance Surface: 20 Yr Coupon Bond

$11,500.00

Dollar Value

$11,000.00

$10,500.00

$10,000.00

$9,500.00

0.5
Passage of Time

$9,000.00

0
0.07

0.08

0.09

Term Structure Indicator

2.
There are two alternative, but equivalent, approaches to this problem. The rst
solution that follows is (perhaps) more intuitive, but the solution tends to ramble.
The second method provides a clear (although algebraic) path toward generating a
solution.
It is immediately obvious that if bonds A an B are priced correctly, then 0 d1 = .935
and 0 d2 = .800. If this is the discount function, then bond C should be selling for
.935 100 + .800 1,110 = 973.5
Bond C is only selling for 960 dollars. This inconsistency implies that there is an
arbitrage opportunity. It would appear that bond C is under priced relative to bonds
A and B. To take advantage of this we can purchase bond C and go short bonds
Chapter 31: Solutions To Questions, Bond Valuation Using Synthetics

Page 1421

Adventures in Debentures

A and B. Assume that we buy 1,000 C bonds. This costs us 960,000 dollars. We
will receive 100,000 dollars in year 1 and 1,100,000 dollars in year 2. Now consider
selling 100 type A bonds and 1,100 type B bonds. This will give us 973,500 dollars.
Subtracting the 960,000 dollars it cost us to purchase the 1,000 type C bonds, we
see that we have a 13,500 arbitrage prot as long as we do not owe anything in the
future. In year 1 we will owe 100,000 dollars to those who purchased our 100 type
A bonds. The coupon payments we receive from our 1,000 type C bonds (which we
bought) total 100,000 dollars. We can therefore pay o the short position on the
100 type A bonds. In year 2 we will owe the holders of the 1,100 type B bond the
1,100,000 dollars but this is exactly what we receive from the 1,000 type C bonds.
Thus, in the future we owe nothing and we receive 13,500 dollars today. Obviously,
there is no reason to do this on the small scale we have just described. If we purchase
twice the number of C bonds and sell short twice the number of A and B bonds, we
make an arbitrage prot of 27,000 dollars. Avarice and unbridled greed should push
us even further in this direction.
Now we turn to a more algebraic approach to the solution, and we begin by formulating an algebraic statement of the desired position. For the moment assume we
want the cash inow in year 0 (CF0) to be +13,500 any positive number would
be acceptable. We want the cash ow in years 1 and 2 (that is, CF1 and CF2) to be
zero. If we could nd such a position, we have found a classic arbitrage. Thus, we
want:
CF 0 : 935NA 800NB 960NC = 13,500
0NB + 100NC =
0
CF 1 : 1000NA +
0
CF 2 :
0NA + 1000NB + 1100NC =
After solving the above three equations in three unknowns, the solution is:
NA = 100 NB = 1100 NC = 1000 .
In the equation labeled CF0, the right hand side was arbitrary. If we found a solution
with any positive number on the right hand side of the CF0 equation, we found an
arbitrage strategy that generated positive net cash ow today and no future net cash
ows. 13,500 was a convenient choice1 given our rst approach at the beginning of
the solution; clearly, both formulations provide the same numerical answer. If we
use a dierent value on the right hand side of CF0, then we would get a dierent
combination of assets A, B, and C, but it would still be an arbitrage.

3.
1

Another convenient choice for the right hand side of equation CF0 is 1. After nding the numerical
solution for an arbitrage prot of one dollar, it is simple to scale up the arbitrage strategy to
generate any level of desired prot.

Chapter 31: Solutions To Questions, Bond Valuation Using Synthetics

Page 1422

Adventures in Debentures

There are two alternative, but equivalent, approaches to this problem. The rst
solution that follows is (perhaps) more intuitive, but the solution tends to ramble.
The second method provides a clear (although algebraic) path toward generating a
solution.
There is an arbitrage opportunity if these four bonds are selling at these prices. One
way to discover the opportunity involves inferring the discount that is consistent
with the prices of some of the bonds, as we did above. If this discount function is
not consistent with the prices of all bonds, then there is an arbitrage opportunity.
Observe rst that bond B can be used to determine 0 d1 , the price paid today for a
dollar to be delivered in one year. We have 93 = (0 d1 )100 or 0 d1 = .93. This is the
value of 0 d1 that justies the price of bond B. Now look at bond C. If 0 d1 were equal
to .93, then 0 d2 , the price paid today for a dollar to be delivered in 2 years, would
have to satisfy
92.85 = (.93)5 + (0 d2 )105
for bond C to be priced correctly. The 0 d2 that satises this is .84. Turn now to bond
A. If 0 d1 = .93 and 0 d2 = .84, then A is correctly priced only if 0 d3 (the current value
of a dollar in 3 years) satises
100.20 = (.93)10 + (.84)10 + (0 d3 )110 .
For this to hold, 0 d3 must equal .75. Now ask what the price of bond D would be if
0 d1 = .93, 0 d2 = .84 and 0 d3 = .75. We have
Justied Price = (.93)20 + (.84)20 + .75(120)
= 18.6 + 16.8 + 90.0 = 125.4 .
This implies that bond D is under priced relative to the other three bonds. This
means that to exploit the arbitrage opportunity we will want to buy D and issue
(short) bonds A, B, and C. Note rst that for every D bond we buy we receive 120
dollars in year 3. An A bond, if shorted, requires that we pay out 110 dollars in year
3. This means we can issue or short 12 A bonds for every 11 D bonds we purchase
and not owe anyone anything in year 3. If we short 12/11 A bonds for every D bond
we purchase, we will receive in year 2 twenty dollars from the D bond we own but we
will only owe 10.90909 dollars on our short position in A bonds. This leaves 9.09091
dollars. We can therefore short 9.09091/105 = .08658 C bonds and payo what is
owed on that short position in year 2 with the 9.09091 we receive. Now look at our
position in year 1. We receive in one year 20 dollars for every D bond purchased
but we owe 10.90909 dollars on the 12/11 A bonds we have shorted and .4329 on the
.08658 C bonds we have shorted. This leaves 8.658 dollars. This means we can short
.08658 B bonds. The position we have taken is given by the simple recipe: for every
D bond purchased, short 1.090909 A bonds, .08658 B bonds, and .08658 C bonds.
If this is done, nothing is owed or received in the future. However, we make (free
Chapter 31: Solutions To Questions, Bond Valuation Using Synthetics

Page 1423

Adventures in Debentures

lunch) money today. The D bond costs 121.2. From the 1.090909 A bonds we short
we receive 109.3090 dollars. From the .08658 shorted B bonds we receive 8.051948
dollars and from the .08658 shorted C bonds we receive 8.0388961 dollars. The total
of the short sale receipts is therefore 125.40 dollars. Since we only pay out 121.2
dollars for the D bond, we make $4.20 for each D bond that we buy.2 Of course,
we need not purchase only one D bond; we can make much greater prots (if prices
remain as they are) by purchasing, say, 10,000 D bonds. Indeed, if prices do not
change, one can make innite prots by taking an innite position. Of course, this is
an absurdity prices must change. If the D bonds price rises to 125.4 the arbitrage
opportunity disappears. Only then can the market be in equilibrium. Otherwise there
is innite demand for the under priced bond.
Now we turn to a more algebraic approach to the solution, and we begin by formulating an algebraic statement of the desired position. For the moment assume we
want the cash inow in year 0 (CF0) to be +4.20 any positive number would be
acceptable. We want the cash ow in years 1, 2, and 3 (that is, CF1, CF2, and CF3)
to be zero. If we could nd such a position, we have found a classic arbitrage. Thus,
we want:
CF 0 : 100.20NA
CF 1 :
10.00NA
CF 2 :
10.00NA
CF 3 :
110.00NA

93.00NB
+ 100.00NB
+
0.00NB
+
0.00NB

92.85NC
+
5.00NC
+ 105.00NC
+
0.00NC

121.20ND
+ 20.00ND
+ 20.00ND
+ 120.00ND

=
=
=
=

4.20
0.00
0.00
0.00

After solving the above four equations in four unknowns, the solution is:
NA = 1.09091 NB = 0.08658 NC = 0.08658 ND = 1 .

In the equation labeled CF0, the right hand side was arbitrary. If we found a solution
with any positive number on the right hand side of the CF0 equation, we found an
arbitrage strategy that generated positive net cash ow today and no future net cash
ows. 4.20 was a convenient choice3 given our rst approach at the beginning of
the solution; clearly, both formulations provide the same numerical answer. If we
use a dierent value on the right hand side of CF0, then we would get a dierent
combination of assets A, B, C, and D, but it would still be an arbitrage.
2

If you nd the fractional units used in this explanation troublesome, consider purchasing 11,550
D bonds and shorting 12,600 A bonds, 1,000 B bonds and 1,000 C bonds. This yields a tidy
arbitrage prot of 48,510 dollars. Check to see that nothing is owed on this position in the future.
Another convenient choice for the right hand side of equation CF0 is 1. After nding the numerical
solution for an arbitrage prot of one dollar, it is simple to scale up the arbitrage strategy to
generate any level of desired prot.

Chapter 31: Solutions To Questions, Bond Valuation Using Synthetics

Page 1424

Adventures in Debentures

4.
Part a. A dedicated portfolio consisting of the zeros would contain:
Maturity Number of Zeros Price Total Cost
1
0
0.9091
0.0000
2
20
0.8000
16.0000
3
45
0.7143
32.1435
4
80
0.6250
50.0000
98.1435

Part b. A dedicated portfolio consisting of the coupon bonds would contain:

Bond Number of Bonds
Price
Total Cost
A
0.0500
98.0874
4.9044
B
10.2055
99.0805 1,011.1660
C
10.0000
104.4055
1,044.0550
D
0.6576
106.6940
70.1620
98.1466

Notice that the cost of the two dedicated strategies in parts a and b are the same
(within rounding error). However, the solution using zeros is easier to calculate and
easier to implement in practice. There are some institutions that could not implement
part b because it involves shorting Bonds A and B.

5.
There are two alternative, but equivalent, approaches to this problem. The rst (and
perhaps more intuitive) solution tries to nd a synthetic and then compares the cost
of the synthetic to the actual security. If the costs of the actual and the synthetic are
dierent, then arbitrage is possible by buying the cheap and selling the expensive.
The second method is similar, but more direct. It looks for an arbitrage strategy
without doing the intermediate step of constructing a synthetic.
To nd an arbitrage opportunity, you must replicate the cash ows of one of the
bonds with a portfolio of the other two. Pick two bonds, and try to form a portfolio
that replicates the payos of the other one. For this problem, it will not matter which
two bonds you pick because you will still nd an arbitrage opportunity.4
4

There may be situations where the selection of the securities to be placed in the synthetic matter.

Chapter 31: Solutions To Questions, Bond Valuation Using Synthetics

Page 1425

Adventures in Debentures

So, assume you are going to replicate Bond C with Bonds A and B. Then, you will
have the cash ows of NA Bond A plus cash ows of NB Bond B equal to the cash
ows of Bond C. That is, the cash ows in year t (i.e., CF t) are:
CF 1:
CF 2:
CF 3:

5NA
5NA
105NA

+
4NB
+
4NB
+ 104NB

=
7
=
7
= 107 .

Note that the second equation is redundant given the rst.

Subtract 21 times CF 1 from CF 3,
105NA + 104NB
105NA 84NB
20NB
NB

= 107
= 147
= 40
= 2 .

Substitute into equation for CF 1:

5NA + 4(2) = 7
5NA = 15
NA = 3 .

So 3 Bond A and (2) Bond B gives the same cash ows as Bond C. The cost of 3
units of Bond A and shorting 2 units of Bond B is 3(100) 2(95) = 110 < 112.
To earn an arbitrage prot of $2, short 1 unit of Bond C, buy 3 units of bond A, and
short 2 units of Bond B.
Now we turn to a more direct approach to the solution, and we begin by formulating
an algebraic statement of the desired arbitrage position. We want the cash inow in
year 0 (CF0) to be +2.00. We want the cash ow in years 1, 2, and 3 (that is, CF1,
CF2, and CF3) to be zero. If we could nd such a position, we have found a classic
arbitrage. Thus, we want:
CF 0 : 100NA
CF 1 :
5NA
CF 2 :
5NA
CF 3 :
105NA

95NB
+
4NB
+
4NB
+ 104NB

112NC
+
7NC
+
7NC
+ 107NC

= 2.00
=
0
=
0
=
0

For example, if you have only one security mispriced relative to a small subset of the total securities,
then you might have to examine more than one case.

Chapter 31: Solutions To Questions, Bond Valuation Using Synthetics

Page 1426

Adventures in Debentures

Since the equations for CF1 and CF2 are identical, we know if we satisfy one of the
equations we are guaranteed to satisfy the other. Thus, eliminate the equation labeled
CF2, which leaves three equations in three unknowns. The solution to the remaining
three equations is
NA = 3 NB = 2 NC = 1 .
Clearly, both formulations provide the same set of numerical answers.

Chapter 31: Solutions To Questions, Bond Valuation Using Synthetics

Page 1427

Adventures in Debentures

Chapter 31: Solutions To Questions, Bond Valuation Using Synthetics

Page 1428