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Arbitrage in Risky Bond and CDS Markets

This document discusses an arbitrage opportunity between the cash and credit default swap (CDS) markets involving a risky one-year zero-coupon bond and Treasury bill. It finds that: 1) The risky bond is priced to yield 6.375% but its fair value, based on the risk-free 2.3% yield, is $93,917. Meanwhile, the CDS premium is priced at $4,500 but its fair value is only $3,821. 2) To exploit this arbitrage, one would short the risky bond, buy the Treasury bill, and sell the overpriced CDS. This yields an upfront profit of $678 with no risk of losses.

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Ashish Malhotra
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30 views2 pages

Arbitrage in Risky Bond and CDS Markets

This document discusses an arbitrage opportunity between the cash and credit default swap (CDS) markets involving a risky one-year zero-coupon bond and Treasury bill. It finds that: 1) The risky bond is priced to yield 6.375% but its fair value, based on the risk-free 2.3% yield, is $93,917. Meanwhile, the CDS premium is priced at $4,500 but its fair value is only $3,821. 2) To exploit this arbitrage, one would short the risky bond, buy the Treasury bill, and sell the overpriced CDS. This yields an upfront profit of $678 with no risk of losses.

Uploaded by

Ashish Malhotra
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as TXT, PDF, TXT or read online on Scribd
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All right, let's move on to Problem 3.

Problem 3 says to consider a risky one-year zero-coupon bond


priced to yield 6.375% on a bond equivalent basis,
where, recall from the Week 3 recitation, that a bond
equivalent yield is the single interest rate that
equates the price of a bond to the present value
of its future cash flows but assumes semiannual compounding.
At the same time, the one-year spot yield on a Treasury bill
is 2.3% on a bond equivalent basis.
A credit default swap is available on the risky bond.
The upfront premium for the credit default swap
is $4,500 per $100,000 face value of the risky bond.
In Part A, we are asked, does there
appear to be an arbitrage opportunity between the cash
and CDS markets?
Explain with a calculation.
First, the value of the risky one-year zero-coupon bond
is equal to the $100,000 face value discounted at 1
plus the 6.375% yield to maturity expressed a decimal.
And since it's on a bond equivalent basis, that
is it assumes semiannual compounding,
we take the yield to maturity divided by 2
and adjust the time unit, which gives us $93,917.35.
A similar calculation could be used
to find the value of the risk-free one-year Treasury
bond as the face value of $100,000 discounted
at the 2.3% risk-free yield to maturity on the bond.
And, again, because it's on a bond equivalent basis,
we divide the yield by 2 and adjust the time unit
for semiannual coupons, which is equal to $97,739.08.
As we saw in the Week 9 lecture, the difference
between the risk-free bond price, this one here,
and the risky bond price, here, is
equal to the fair price of the credit default swap
premium, which in this case is equal to $3,821.73.
Thus, there appears to be an arbitrage opportunity
as the credit default swap is selling for $4,500
and appears to be relatively overpriced
relative to its fair value of $3,821.
Part B asks, describe the transactions
that you would have to simultaneously make
in both the cash and the CDS markets
in order to exploit this arbitrage opportunity.
Well, since the CDS is overpriced
relative to its fair value, the most straightforward way
to structure the transactions is to do the following.
First, sell the credit default swap.
Second, purchase a one-year Treasury bill with face value
equal to $100,000.
And, third, short the risky one-year zero-coupon bond
with face value equal to $100,000.
The upfront profit from this strategy
is equal to the $4,500 from selling the CDS minus $97,739
from purchasing the one-year Treasury bill plus $93,917
from shorting the risky one-year zero-coupon bond, which
is equal to $678.27.
Notice that this strategy has zero future cash flows
paid or received from the strategy.
So it's certainly an arbitrage opportunity
with a positive payoff initially and no possibility
of paying money in the future.
Why is this the case?
Well, if the risky bond defaults,
that is the risky bond that we shorted,
then the credit default swap payment
is covered by the difference between the face
value of the Treasury bill and the recovery
value of the risky bond.
If the risky bond, on the other hand, doesn't default,
then the credit default swap pays
nothing and the face values of the one year Treasury bill
of $100,000 and the risky one-year zero-coupon bond
cancel out on both the long and short positions.

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