Mack uses the benchmark yield curve provided in Exhibit 2 to consider arbitrage

Question

Mack uses the benchmark yield curve provided in Exhibit 2 to consider arbitrage opportunities of both option-free corporate bonds and corporate bonds with embedded options. The benchmark bonds in Exhibit 2 pay coupons annually, and the bonds are priced at par.

Mack then identifies three mispriced three-year annual-pay bonds and compiles data on the bonds (see Exhibit 3).

1. Based on Exhibits 2 and 3 by discounting each year’s cash flow separately using the appropriate interest rate curve, what is the amount (in absolute terms) by which the Durant corporate bond is mispriced?

2. This method of discounting each year's CF using the appropriate interest rate curve would most likely not be an appropriate valuation technique for the bond issued by (chose from the following):

a. Durant Inc.

b. Westbrook Intl.

c. Hamon Corp.

EXHIBIT 2 Benchmark Par Curve Maturity (years)Yield to Maturity (YTM) 3.0% 4.0% 5.0% 2 Spot Rate Year 1 Spot Rate Year 2 Spot Rate Year 3 3.00% 4.02% 5.07%

Explanation / Answer

1) Price of Durant Bond = CF1 / (1 + s1) + CF2 / (1 + s1) x (1 + s2) + CF3 / (1 + s1) x (1 + s2) x (1 + s3)

= 3 / 1.03 + 3 / (1.03 x 1.0402) + 103 / (1.03 x 1.0402 x 1.0507)

= 97.2092

Mispricing = 97.2092 - 94.9984 = 2.2108

2) This method would not be appropriate for Westbrook Intl as it has embedded option attached to the bond, which needs to be accounted as well.

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