The Following Information Relates to Questions
Betty Tatton Is

question 14

Multiple Choice

The following information relates to Questions
betty tatton is a fixed income analyst with the hedge fund Sailboat asset Management (SaM) .SaM invests in a variety of global fixed-income strategies, including fixed-income arbitrage.tatton is responsible for pricing individual investments and analyzing market data to assess the opportunity for arbitrage. She uses two methods to value bonds:
Method 1: Discount each year's cash flow separately using the appropriate interest rate curve.
Method 2: build and use a binomial interest rate tree.
tatton compiles pricing data for a list of annual pay bonds (exhibit 1) . each of the bonds will mature in two years, and tatton considers the bonds as being risk-free; both the one-year and two-year benchmark spot rates are 2%. tatton calculates the arbitrage-free prices and identifies an arbitrage opportunity to recommend to her team.exhibit 1 Market Data for Selected bonds
$\begin{array} { l c r } \text { Asset } & \text { Coupon } & \text { Market Price } \\\hline \text { Bond A } & 1 \% & 98.0584 \\\text { Bond B } & 3 \% & 100.9641 \\\text { Bond C } & 5 \% & 105.8247 \\\hline\end{array}$
next, tatton uses the benchmark yield curve provided in exhibit 2 to consider arbitrage opportunities of both option-free corporate bonds and corporate bonds with embedded op-tions. The benchmark bonds in exhibit 2 pay coupons annually, and the bonds are priced at par.exhibit 2 benchmark Par Curve
$\begin{array} { l c } \text { Maturity (years) } & \text { Yield to Maturity (YTM) } \\\hline 1 & 3.0 \% \\2 & 4.0 \% \\3 & 5.0 \% \\\hline\end{array}$ tatton then identifies three mispriced three-year annual-pay bonds and compiles data onthe bonds (see exhibit 3) .
exhibit 3 Market Data of annual-Pay Corporate bonds $$\begin{array} { l c c c c } \text { Company } & \text { Coupon } & \text { Market Price } & \text { Yield } & \text { Embedded Option? } \\\hline \text { Hutto-Barkley Inc. } & 3 \% & 94.9984 & 5.6 \% & \text { No } \\\text { Luna y Estrellas Intl. } & 0 \% & 88.8996 & 4.0 \% & \text { Yes } \\\text { Peaton Scorpio Motors } & 0 \% & 83.9619 & 6.0 \% & \text { No } \\\hline\end{array}$$
last, tatton identifies two mispriced Swiss bonds, ond x, a three-year bond, and bond Y, a five-year bond. both are annual-pay bonds with a coupon rate of 6%. to calculate the bonds' values, tatton devises the first three years of the interest rate lognormal tree presented in exhibit 4 using historical interest rate volatility data. tatton considers how these data would change if implied volatility, which is higher than historical volatility, were used instead.
exhibit 4 interest rate tree; Forward rates based on Swiss Market

-based on exhibit 4 and using Method 2, the correct price for bond x is closest to:

• A) 97.2998.
• B) 109.0085.
• C) 115.0085.

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Definitions:

Perfectly Price-inelastic

A situation where the quantity demanded of a good does not change regardless of changes in its price.

Price-inelastic

Referring to a situation where demand or supply for a good or service is relatively unresponsive to changes in price.

Total Revenue

The aggregate income a company generates from its sales of products or delivery of services over a designated period.

Price Falls

A decrease in the market price of a good or service, which can affect consumer demand, producer supply, and overall market equilibrium.