Topic 3

Introduction to the
Valuation of Fixed Income Instruments

FINA 4120 - Fixed Income 1

 Topic 3: Outline

• Absolute Pricing
– Dirty price and clean price*

• Relative Pricing
– Law of One Price
– No-arbitrage Pricing*

• RJR Nabisco CaseJ

FINA 4120 - Fixed Income 2

 Additional assignment during this weekend

• Read the AER paper on the case of RJR Nabisco

– Uploaded at Blackboard
• Watch a movie – “Barbarians at the gate”

FINA 4120 - Fixed Income 3

Relative Pricing --- No Arbitrage

FINA 4120 - Fixed Income 4

 Arbitrage Profits
• Non-technical Definitions - Arbitrage profits are:
– Guaranteed profits earned at zero cost.
– Getting “something for nothing.”
– Getting a “free lunch.”
• Technical Definition - arbitrage profits are earned
on an investment when either:
(1) You earn a positive profit for sure today and pay at
most zero in the future.
(2) You earn a positive profit for sure in the future and
pay at most zero today.
(3) Your cumulative net cash flows are never negative and
are positive in at least one period
FINA 4120 - Fixed Income 5
 The three-steps of arbitrage

1. Identify relative mispricing

2. Buy low (underpriced) and sell high (overpriced)
3. Construct CF tables and verify it is an arbitrage

FINA 4120 - Fixed Income 6

 Arbitrage: Example 1

• Two treasury strips, M matures in one period, and

N matures in two periods.
– M is selling at $70, while N is selling at $ 80
– Both M and N has face value of $ 100
– Arbitrage opportunity?
• Yes!
• N is over-priced (why?)

FINA 4120 - Fixed Income 7

 Arbitrage: Example 1 (continue)
• Strategy:
– Short N and Buy M
– Positive cumulative net cash flow
Points in time
0 1 2
Short N +80 - -100
Buy M -70 +100 -
Net Cash Flow +10 +100 -100
Cum. Net Cash Flow +10 +110 +10
• Implication
– Arbitrage opportunity will disappear eventually
– Arbitrage guarantees the time value of money

FINA 4120 - Fixed Income 8

 Arbitrage: Example 2

• Assume two coupon bonds, G and H

– Both are two-periods, with face value of $100
– G has a coupon of $6, and H has $8 coupon
– Both are selling at face value
– Arbitrage opportunities?
• Yes!
• G is over-priced (or H is under-priced)

FINA 4120 - Fixed Income 9

 Arbitrage: Example 2 (continue)
• Strategy:
– Short G and buy H
– Positive cumulative net cash flow
Points in time
0 1 2
Short G +100 -6 -106
Buy H -100 +8 +108
Net Cash Flow 0 +2 +2
Cum. Net Cash Flow 0 +2 +4
• Implication
– Eventually arbitrage opportunity will disappear
– Arbitrage guarantees that bond with higher coupon
must have higher price
FINA 4120 - Fixed Income 10
 Arbitrage Example 3

• A two-period coupon bond K has $6 coupon, $100

face value, and is selling at par
• One period zero-coupon bond (strip) L is selling at
$94.34
• Two period zero-coupon bond (strip) M is selling
at $85.73
• Arbitrage opportunity?
– Yes!
– Bond K is over-priced (why?)

FINA 4120 - Fixed Income 11

 Arbitrage Example 3 (continue)
• Strategy
– Short 1 K
– Buy 6% of L and buy 106% of M
– Positive cumulative net cash flow
0 1 2
Short K +100 -6 -106
Buy 6% of L -5.66 +6 -
Buy 106% of M -90.87 - +106
Net Cash Flow +3.47 0 0
Cum. Net Cash Flow +3.47 +3.47 +3.47
• Implication
– Arbitrage occurs if a particular security can be created
from a portfolio of other securities at a lower price
FINA 4120 - Fixed Income 12
 Arbitrage Example 4
• Assume that there are two two-year coupon-
bearing bonds. Bond H has an annual coupon of
$6.25 and par value of $100. Bond G has an
annual coupon of $4 and par value of $100.
Bond H is selling at $94.50 and bond G is selling
at $90.
• Is there an opportunity of arbitrage? Why or
why not?

FINA 4120 - Fixed Income 13

 Arbitrage Example 4 (continue)

• 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

Net Cash Flows $ 4.50 -$2.25 -2.25

Cum. Cash Flows $4.50 +$2.25 +$0.00

• Arbitrage Profit?

FINA 4120 - Fixed Income 14

 Arbitrage Example 4 (continue)

• Strategy 2:
Points in Time 0 1 2
Buy 102.16% G - $91.94 + $4.0865 + $106.25
Short 1 H + $94.50 -$6.25 -$106.25

Net Cash Flows $ 2.56 -$2.1635 0

Cum. Cash Flows $2.56 +$0.3965 +$0.3965

FINA 4120 - Fixed Income 15

 Sample Question
Consider a hypothetical Payment in Kind (PIK) bond of XYZ
Corporation.
The bond has 2 years to maturity, a face value of $1000, and has an
annual coupon rate of 10%. Coupons are paid annually.
XYZ has the right to pay the first coupon either in cash or in
additional PIK bonds – i.e., the bond holder may get either $100 in
cash or 10 additional PIK bonds for every 100 bonds she has. The
second coupon must however be paid in cash along with the face
value at the end of two years.
The PIK bonds are risk free and trade at par while the yield curve is
flat at 9% -- risk free 1 year and 2 year zero coupon bonds trade at
a yield to maturity of 9% (Effective Annual Yield).
Suppose you can buy and short sell (borrow and sell) the PIK and
zero coupon bonds without transactions costs. You forecast that
the yield to maturity on one year zero coupon bonds one year from
now will either stay at 9% or change to 8.5% or 9.5%.
FINA 4120 - Fixed Income 16
a) Assume XYZ always pays the first coupon in
cash, what should be the price of the bond?
b) Given your forecast on future interest rate (as
stated in the problem), show that there is an
arbitrage opportunity.
c) Assuming that your forecast holds, construct a
portfolio of the PIK bonds and one year and two
year zeros such that you get positive cash flow
today and no negative cash flows in the future.
Show the cash flow table with net cash flows and
cumulative cash flows over time.
FINA 4120 - Fixed Income 17
 Answer

a) Where XYZ always pays the first coupon in cash, then the
PIK bond becomes a standard coupon bond. Its price
should be:

100/1.09 + 1100/1.09^2 = 91.74 + 925.85 = 1017.59.

FINA 4120 - Fixed Income 18

 Answer
b) The trick is to note that the payment in kind option will not be exercised
given your forecast.
Consider the firm that issued the PIK bond. One year from now the firm can
either pay $100 coupon in cash or pay 0.10 PIK bond – the latter is equivalent
to paying $110 in two years instead of paying $100 in one year.
Hence paying in kind (the 0.10 PIK bonds) would be attractive if and only if
the $100 dollar that would have been paid as cash coupon, can earn a riskless
interest rate of more than 10%.
Given your forecast that the one year interest rate one year from now will be
either 8.5%, 9% or 9.5%, the firm if it acts rationally, will opt to pay the
coupon in cash in year one. Hence the 10% PIK bond is equivalent to a 10%
cash coupon bond and should be priced at $1017.59. However, the bond is
currently undervalued at par. There is an arbitrage.

FINA 4120 - Fixed Income 19

 Answer

As always, you want to buy LOW and sell HIGH. Therefore, buy the PIK bond and short a zero-coupon
bond that pays $100 in one year and a zero-coupon bond that pays $1100 in two years. The cash
flows are:

T=0 T=1 T=2

Buy PIK Bond -1000 100 1100
Short 1-yr zero 91.74 -100 -
Short 2-yr zero 925.85 - -1100
Net cash flow 17.59 0 0
Cumu. net cash flow 17.59 17.59 17.59

FINA 4120 - Fixed Income 20

 No-Arbitrage Pricing and Arbitrage Profits
• No-Arbitrage pricing principles is a popular way to
determine what the price of a security should be.
– Also called relative valuation.
– Particularly popular when discussing pricing of
derivatives.
– Often used intuitively to determine value (e.g. forward
rate example later).
– Most popular way for professionals in the “real world” to
value financial securities.

FINA 4120 - Fixed Income 21

 No-Arbitrage Pricing and Arbitrage Profits
• Idea:
– Take a security you want to price or “value”.
– Using another security, or set of securities (portfolio),
with known price(s), mimic the payoff of the security
you want to value. Such a collection of securities is
called a synthesizing or replicating portfolio.
– Law of One Price: In the absence of arbitrage profit
opportunities, the value of the security you want to
price should equal the cost of the mimicking strategy.
• No Arbitrage => Law of One Price
• Question: Does Law of One Price => No arbitrage?

FINA 4120 - Fixed Income 22

 Arbitrage Pricing – Simple Example

• Suppose there are three T-strips as follows:

– 1-period T-strips selling for $98 for $100 par value
– 2-period T-strips selling for $96 for $100 par value
– 3-period T-strips selling for $94 for $100 par value
• A 3-period T-note has $5 per-period coupon
payment and $100 par value.
• What should be the price of the 3-period T-note if
there is no arbitrage opportunity?

FINA 4120 - Fixed Income 23

 Arbitrage Pricing – Simple Example
(continue)
• It’s easy to replicate the cash flows of the 3-period T-
note by a combination of the T-strips as follows:
Periods 0 1 2 3
Buy 5% of 1-period T-strips -$4.90 +$5 - -
Buy 5% of 2-period T-strips -$4.80 - +$5 -
Buy 105% of 3-period T-strips -$98.70 - - $105
CF of the Replicating Portfolio -$108.40 +$5 +$5 $105

• The cost of the replicating portfolio is $108.40. Therefore, the

3-period T-note must be selling at $108.40.

FINA 4120 - Fixed Income 24

 Arbitrage Pricing – Simple Example
(continue)
• What if the price of the T-note is not equal to that of the
replicating T-strip portfolio?
– Arbitrage
– How: BUY LOW, SELL HIGH!
• If the T-note is relatively cheap
– Buy the T-note, sell each cash flow as a separate T-strip (This
is called Stripping)
• If the T-note is relatively expensive
– Buy individual T-strips, form a T-note and sell it (This is called
Reconstitution)

FINA 4120 - Fixed Income 25

 Arbitrage?

FINA 4120 - Fixed Income 26

 No-Arbitrage Pricing and Absolute Pricing

• 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 4120 - Fixed Income 27
Absolute Pricing --- DCF

FINA 4120 - Fixed Income 28

 Recall
• Computing the price or yield of a coupon bond on
issuance date or right after a coupon payment is easy
C1 C2 C3 CT -1 CT
P= + + + ! + +
1 + y (1 + y ) 2 (1 + y )3 (1 + y )T -1 (1 + y )T
T
Ct
=å
t =1 (1 + y )t
– The nth cash flow in the future will be paid exactly n periods
away

• What if the bond is traded in between coupon payments?

FINA 4120 - Fixed Income 29

 Computing yields and prices when the settlement
date falls between coupon payments

• What happens when a bond is sold between coupon periods?

FINA 4120 - Fixed Income 30

The “dirty” price or “invoice” price is the
present value of the remaining cash
flows. It is the price the buyer actually
pays, including accrued interest:

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

w = (# days between settlement and

next coupon) ÷
(# days in coupon period)

n = number of remaining coupon

payments

F = face value

FINA 4120 - Fixed Income 31

Computing yields and prices when the settlement
date falls between coupon payments
• The quoted price is the “clean” or “flat” price. It can be
thought of as the price “as if” the next coupon were six months
away.
• clean price = dirty price - accrued interest
• accrued interest = (1-w)C
• w = (# days between settlement and next coupon) ÷ (# days in
coupon period)
• In Excel:
• "PRICE" returns the clean price, given the quoted yield and other
information.
• "YIELD" returns the yield, given the clean price and other
information.
• "ACCRINT" returns the accrued interest, given dates and other
information.

FINA 4120 - Fixed Income 32

 Day Count Conventions for Accrued Interest (AI)*

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.

*from Bond Market Securities by Moorad Choudhry, Prentice Hall

FINA 4120 - Fixed Income 33

 Day Count Convention

• Coupon-bearing Treasury Securities:

– Actual/Actual

• Agency, Municipal and Corporate Bond:

– 30/360

• When there is no coupon payment, accured

interest is zero, the bond is be traded flat

FINA 4120 - Fixed Income 34

 Example: Calculating Accrued Interest
Buy 8 1/2% Treasury note quoted at clean price P=$1010 (per $1000
face)
Maturity Date: July 1, 2018, Settlement Date: May 1, 2016
• How much interest must you pay per $1000 face value?
Date 2017 2018
1/1 5/1 7/1 1/1 7/1 1/1 7/1
Cash flows
42.5 42.5 42.5 42.5 42.5 1042.5

1/1/16 - 5/1/16 = 121 days

1/1/16 - 7/1/16 = 182 days

Accrued interest = (121/182)$42.5 = $28.26 in interest.

• Total payment is $1038.26, the dirty price.

• Yield is 7.98%, calculated in Excel.

FINA 4120 - Fixed Income 35

 Practice question (mid-term example)

• Suppose that a Treasury Note with a coupon rate of 7.4%

is purchased between coupon periods. The days between
the settlement date and the next coupon date is 115. There
are 183 days in the coupon period. The price of the T-Note
quoted on the WSJ is 107.500. What’s the dirty price of
the bond (assume a par value of a $100)?

(a) $106.125
(b) $108.535
(c) $108.875
(d) $109.825

FINA 4120 - Fixed Income 36

 Answer

• The accrued interest is: $7.4/2 * (1 – 115/183) =

1.3749
• Dirty price = clean price + AI = 107 .500 +
1.3749 = 108.875

FINA 4120 - Fixed Income 37

 Example: A WSJ example

The quote below is obtained from September 30, 2015 WSJ

Maturity Coupon Bid Asked Chg Asked Yield

5/31/2017 2.75 103.5938 103.6094 0.0313 0.57

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%

FINA 4120 - Fixed Income 38

 Example: A WSJ example
Days Calculation
• Step 1: Compute the Settlement Date 10/1/15
Accrued Interest Prior Coupon Payment Date 5/31/15
Next Coupon Payment Date 11/30/15
Coupon Payment 1.375
Days Between Payments 183
• Step 2: Compute the Days Past Since Last Coupon 123
dirty price as
quoted price + Accrued Interest and Invoice Price
accrued Interest Quoted Ask 103.6094
Accrued Interest 0.9242
Invoice Price 104.5336

FINA 4120 - Fixed Income 39

 Example: A WSJ example
• Step 3: Find the BEY such that the sum of discounted cash
flows is equal to the dirty price
– Calculation done in Excel

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)

FINA 4120 - Fixed Income 40

 A Side Point: Why bother quoting clean price?
• Take a 10yr treasury note with 8% coupon and assume YTM = 8%
• This bond should trade at par, except for the timing of coupons.
• The AI convention ensures that the quoted flat price is around 100

Bond Prices

105.0000
104.0000
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

FINA 4120 - Fixed Income 4/15/2001 41

Computing prices when there are multiple
discount rates

• The Same Discounted Cash Flow Idea:

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
=å
t =1 (1 + rt )
t

• The discount rate rt is the yield on a zero-coupon

bond maturing at t (aka spot rate)

FINA 4120 - Fixed Income 42

 Example
• A three-year coupon bearing bond has an annual
coupon of $50 and par value of $1,000. You
observe the following spot rates: r1=5%, r2=5.5%,
and r3=6%. What’s the price of the bond?

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

FINA 4120 - Fixed Income 43

 Limits to 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

FINA 4120 - Fixed Income 44

 ‘Near’ Arbitrage

• 2008 Earthquake

FINA 4120 - Fixed Income 45

‘Near’ Arbitrage

FINA 4120 - Fixed Income 46

On Homework

FINA4120– Fixed Income 47

 On Homework

• “Lightly, caressingly, Marie Antoinette picked up

the crown as a gift. She was still too young to
know that life never gives anything for nothing,
and that a price is always exacted for what fate
bestows.”

― Stefan Zweig, Marie Antoinette: The Portrait of

an Average Woman

FINA4120– Fixed Income 48

 When arbitrage goes wrong-
A simple example
• Similar situation as example 2, but needs to post
collateral for potential losses of short position
• At period 1, the price of G goes up to $105, while
H remain at $100 (perhaps because investors think
G is much less risky)
• Need to post $5 as collateral.
• Forced to liquidate the position if no collateral is
posted.
– Cover the short and make a loss of $5

FINA 4120 - Fixed Income 49

 When arbitrage goes wrong
- Long Term Capital Management
• Long Term Capital Management (LTCM)
– Hedge fund started in 1994 by John Meriwhether.
– Employed former Salomon Bros. Traders plus lots of PhD
economists and mathematicians (including 2 Nobel Prize-
winning finance professors, a vice chairman of Fed
Reserve).
– Idea: Find “near” arbitrage opportunities in fixed income
market. Use sophisticated math models to find replicating
portfolios.
– Convergence trading: “Suck up nickels around the world”

FINA 4120 - Fixed Income 50

 Yield Curve Strategies from DB Fixed Income Research
1/22/2016
Regress Y7-(Y5+Y10)/2 on Y7

Relative to 5y and 10y, is 7y note too expensive or too cheap?

FINA 4120 - Fixed Income 51

 LTCM --- Leverage

• In order to make more money, must take large

leveraged positions.

FINA 4120 - Fixed Income 52

LTCM --- Performance

FINA 4120 - Fixed Income 53

 Limits to Arbitrage
- Long Term Capital Management
• Example: Bet on convergence of European bond
market after introduction of Euro.
– German bonds were “overpriced” (yields too low),
Belgian bonds were “underpriced” (yields too high).
– Bet: Yields must converge.
• Problem: take large leveraged positions.
– What if yields don’t converge.

FINA 4120 - Fixed Income 54

 Limits to Arbitrage
- Long Term Capital Management
• Fall 1998
– Asian financial crisis + collapse of Russian financial
system.
– Leads to “flight to safety” - U.S. and German bonds.
– German bond prices rise (yields fall), Belgian prices
fall (yields rise).
• Other LTCM positions
– U.S. Treasury (overpriced) versus Russian bonds
(underpriced).
– U.S. Treasury (overpriced) versus U.S. Corporate
(underpriced)
FINA 4120 - Fixed Income 55
 LTCM

FINA 4120 - Fixed Income 56

 Limits to Arbitrage
- Long Term Capital Management
• The rescue of LTCM
– Warren Buffett’s offer
– Bailout by a consortium of 14 banks and brokerage
firms (Sep 28, 1998)
– The curse of LTCM

• Aftermath
– JM started another hedge fund just a year later
– Merton and Scholes returned to teaching
– The consortium recover their investment completely

FINA 4120 - Fixed Income 57

 What are the lessons from LTCM?

• Be careful of what you wish for --- there is a limit

to arbitrage

• Leverage is a double-edged sword

• You can’t float without liquidity

Read “When Genius Failed: The Rise and Fall of LTCM”

FINA 4120 - Fixed Income 58

Can fixed-income mis-pricing happen in real
world?
The Answer is Yes!

• The RJR Nabisco Case

FINA 4120 - Fixed Income 59

 The Case of RJR Nabisco
Holdings Capital Corporation

• Outline
– Background (LBO and Junk Bond)
– Understand the securities involved
– Theoretical no-arbitrage pricing restriction
– Arbitrage strategy
– What happened?

FINA 4120 - Fixed Income 60

 Based on

“The Relative Pricing of High-Yield Debt: The Case

of RJR Nabisco Holdings Capital Corp”

Robert M. Dammon
Kenneth B. Dunn
Chester S. Spatt

American Economic Review (1993), Vol 83 No.5, 1090-1111

FINA 4120 - Fixed Income 61

 Leveraged Buyout (LBO)
• A strategy involving the acquisition of another company using a
significant amount of borrowed money (bonds or loans) to meet
the cost of acquisition.

• Often, the assets of the company being acquired are used as

collateral for the loans in addition to the assets of the acquiring
company.

• The purpose is to allow companies to make large acquisitions

without having to commit a lot of capital.
– It's ironic that an acquired company's success (in the form of cash on the balance
sheet) can be used against it as collateral by the hostile company that acquires it.
– For this reason, some regard LBOs as an especially ruthless predatory tactic.

FINA 4120 - Fixed Income 62

 Junk Bond and Mike Milken

• In a LBO, there is usually a ratio of 90% debt to 10% equity

• The bonds are usually not investment grade and are referred
to as junk bonds (High-yield bonds).

• Michael Milken (nicknamed "The Junk Bond King" ) almost

single-handed created the market for Junk bonds during the
1970s-1980s.

• He was charged in 1989, paid a total of $900 million in fines

and still had over one billion dollars in personal fortune
intact.
FINA 4120 - Fixed Income 63
 Background of the Case

• 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 4120 - Fixed Income 64
 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 4120 - Fixed Income 65
FINA 4120 - Fixed Income 66
 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

• Put Provision – only in case of a change in control

– Cash and PIK bonds can be sold back to RJR by the holder at 101% of par plus
accrued interest
– Deferred bond can be sold back to RJR at 101% of its accreted value (given by
the schedule that assigns value based on 15% discount)

FINA 4120 - Fixed Income 67

 RJR Nabisco Bonds
• Call Provision
– All bonds are not callable prior to May 15, 1994, except in the event
of a change in control
– All bonds are callable after May 15, 1994 at the call-price schedules
below

FINA 4120 - Fixed Income 68

 Pricing Restriction

• T*: May 15, 1994

• v: the dirty price; p: the clean (quoted) price
• c: Cash Bond, p: PIK Bond, d: Deferred Bond

• Before T*, both p and d are traded flat:

vtd = ptd , vtp = ptp for t £ T *

• After T*, p and d become identical and both are better

than c: v c £ v d = v p for t ³ T *
t t t

FINA 4120 - Fixed Income 69

 Relative Mis-pricing

c
Cash Bond

3
1

d 2 p
Deferred Bond PIK Bond

FINA 4120 - Fixed Income 70

 Cash Bond ó Deferred Bond
• Consider
(1) The Cash Bond
(2) Deferred Bond + T-Strips mimicking coupons before T*

• Cash flows of (2) are larger and less risky than those of (1)

• No arbitrage => price of (1) < price of (2)

m
v < p + 6.75å qit < ptd + 6.75m
c
t
d
t (1)
i =1
th
qit is the price of a T-strip that pays $1 at i coupon payment date

FINA 4120 - Fixed Income 71

 Cash Bond ó Deferred Bond

• Large Arbitrage Profit --- $5 per $100 face value

FINA 4120 - Fixed Income 72

 Deferred Bond ó PIK Bond
• Consider a Hypothetical PIK Bond (pk) that always pays
coupon in the form of new PIK Bond
– Its face value grows by 7.5% every coupon-paying-period
– Let n denote the number of periods before T*
– At T*, you need (1.075)n of d to replicate pk, therefore:
ptpk = (1.075) n ptd
• In the actual PIK bond, RJR Nabisco has the option to pay
coupon as cash or new PIK bond
– The option is good for the company, therefore bad for the investor:

wt = ptpk - ptp = (1.075) n ptd - ptp > 0 (2)

FINA 4120 - Fixed Income 73

 Deferred Bond ó PIK Bond

• Some mis-pricing

FINA 4120 - Fixed Income 74

 PIK Bond ó Cash Bond
• Combine restriction (1) and (2)

p p
+ w m
vtc < t t
n
+ 6.75å qit
(1.075) i =1

• Put a upper bound on wt --- Assume PIK bond trades like

Treasury so option value wt is maximized, then:
n
é æ n
ö ù
p + å ê( 0.075) ç 7.5 å qkt + 107.5qnt ÷ - 7.5qit ú
t
p
m
i =1 ë è k =i +1 ø û
vt <
c
n
+ 6.75å qit (3)
(1.075) i =1

FINA 4120 - Fixed Income 75

 PIK Bond ó Cash Bond

• Large mis-pricing

FINA 4120 - Fixed Income 76

Overall, Cash Bond is too expensive

FINA 4120 - Fixed Income 77

 Mis-pricing quite difficult to explain

• Difficult in Short-Sale?
– Doesn’t explain why someone will buy Cash Bond at
such a high price

• Small issue size, nobody notices?

– Issue size quite large
– Look at all the publicity around RJR LBO
– Several Wall Street firms indeed noticed

FINA 4120 - Fixed Income 78

 Mis-pricing quite difficult to explain

• Tax?
– Explain at most 25% of the arbitrage profit

• Liquidity?
– No, the PIK and Deferred Bond are actually more liquid

• More bargaining power associated with the Cash Bond?

– Not enough

• Investor’s preference for cash?

– If so, go and buy T-strip + Deferred Bond

FINA 4120 - Fixed Income 79

 Aftermath

• Mis-pricing largely disappeared by Mar 1991

– That was when the authors decided to make their
findings publicJ

FINA 4120 - Fixed Income 80