Case Study: Arbitrage in the Government Bond Market?
Directions:
The case write-up should be no more than five pages, double-spaced and answer the following four
questions. Case Questions:
1) Create the two synthetic bonds described in the case. How should the price of these synthetics
relate to the callable bonds? Why? On January 7, 1991, how much would it cost to create the
synthetic using the ‘05s? The ‘00s?
2) On January 7, 1991, how could Thompson exploit this apparent anomaly for investors who own
the 8.25 May ’00-05? What can investors not owning the callable bond do to profit?
3) What might underlie the odd relative prices of the bonds Thompson is considering?
4) Why should the treasury issue callable debt? When should they exercise their right to call or
redeem the bonds? Why would corporations issue callable debt? Why should investors want to
buy callable debt?
