An investment manager takes account of a large and supposedly obvious inconsistency in the prices of almost similar bonds that were issued in aggregation with a significant leveraged buyout. The manager must discern whether the tools are priced wrongly in relation to one another. If this is the case, he must also understand how to make revenue from the short-lived anomaly. The allows the students to comprehend a broad range of tools, from simple treasury slips to P-I-K debentures. It also motivates the students to formulate ‘arbitrage’ roles and comprehend the extent to which these roles may be without a risk.
1. What package of Discount Debentures and Treasury STRIPs would produce one "synthetic" 13.5% Debenture? On January 15, 1991, how much would it cost Ms. Samuels to buy the components of one synthetic 13.5% bond using Discount Debentures plus Treasury STRIPs?
2. How will the synthetic 13.5% and the RJR 13.5% Debentures perform differently over time? You may want to consider factors including, but not limited to, how the two instruments are affected by interest rate changes, changes in RJR's credit rating, etc.
3. How could Ms. Samuels profit from the relative mispricing of the RJR 13.5% Debenture and the Discount Debentures? What advice might she give to the following of her clients, each of whom does not pay any taxes?
a) Client A already owns the 13.5% RJR Debenture.
b) Client B does not own the 13.5% RJR Debenture.
Of what risks should Ms. Samuels advise her clients, if they follow her advice? Would you expect the relative prices to remain as they are on January 15, 1991? Why or why not? What will Ms. Samuels advise later if the relative prices of the 13.5% Debenture and the synthetic change dramatically? What might explain the relative pricing in January 1991 of the Discount Debentures and the 13.5% Debentures?
4. At issue, do you think the three debentures were appropriately priced relative to treasuries and relative to one another? How do the specific terms of the instruments affect these relative prices? Why do you think RJR Nabisco chose to structure its debt using three terms? In November 1994, what would you expect the prices of the three debentures will be, relative to one another?