arbitrage in the government bond market
In 1991, major discrepancies in the prices of multiple long maturity US Treasury bonds seemed to appear in the market. An employee of the firm Mercer and Associates, Samantha Thompson, thought of a way to exploit this opportunity in order to take advantage of a positive pricing difference by substituting superior bonds for existing holdings. Thompson created two synthetic bonds that imitated the cash flows of the 8¼ May 00-05 bond; one for if the bond had been called at the year 2000, and one for if it hadn’t been called and was held to its maturity at year 2005.
The first synthetic bond combined noncallable treasury bonds that matured in 2005 with zero coupon treasuries …show more content…
Thompson would borrow the 00-05 treasury bond from a dealer and then sell it. With that money, she would buy a synthetic bond and wait for the 00-05 treasury bond to decrease in price as prices converge. Once they do, she would buy the 00-05 bond for a lower price and give it back to the dealer, while pocketing about $2 (given that she bought the 2005 synthetic bond). There’s plenty of risk when trying to take advantage of pricing arbitrage. For example, the prices may never converge and Thompson might end up waiting almost 15 years without anything happening. Another risk is that the dealer might call the bond back while the money is tied up in the synthetic bond. Because of these risks, it might be better if she doesn’t try and take advantage of the pricing arbitrage at all.
Through close examination, a multitude of factors could have come into play resulting in the odd pricing of Thompson’s evaluated bonds. In studies conducted by Longstaff (1992) and Eldeson, Fehr, and Mason (1993) they found that negative option values were very common, ultimately implying that callable treasury bonds were significantly overpriced (35). Although it seems odd to have a negative option value, Thompson found herself in a rapidly changing bond market with the earlier introduction of derivative securities and STRIP bonds. With the introduction of STRIP bonds in 1985, problems arise in