Callable Bonds Case Study

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Arbitrage in the Government Bond Market (Case Analysis) Overview: On January 7, 1991, Samantha Thompson found out that there were major discrepancies in prices of long-term US Treasury bonds, and this anomaly could be used to make an arbitrage profit. Since the market is the largest, most liquid and closely watched fixed-income market in the world, it is uncommon to find an arbitrage opportunity in the government bond market. Ms. Thompson observed that she could create a synthetic bond whose coupon rate, maturity and par value could be exactly the same as the callable bond by combining non-callable bonds and zero coupon bonds. Clearly, this new bond is better than callable bond. If Ms. Thompson’s analysis was right, for investors holding callable bonds, they could make money from these discrepancies. Investors who don’t hold the callable bond can short sell the relatively overpriced security and buy the relatively underpriced one. 1. Create the two synthetic bonds described in…show more content…
However, according to the research, the average bid-ask spread is huge in the callable government bond market, the callable bonds are somewhat illiquid.  Tax consideration For investors who need to pay for the tax, they need to keep adjusting their position continuously. For a long-term arbitrage portfolio, it is hard to manage the risk for the adjustment.  Cost of short selling and repurchase agreement Short selling and repo certainly have risk and transaction cost (broker fee and initial margin). But for investors who own the callable bonds, costs of repo and short selling don’t exist.  Conclusion: The existence of costs for taxation and transaction can only partially explain why arbitrage opportunity exists for a long time. It might be that the number of arbitrageurs is relatively small and they have inadequate capital, their ability to drive market prices to fundamental values is

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