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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 fixedincome 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 years 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 Asset Coupon Market Price Bond A 1% 98.0584 Bond B 3% 100.9641 Bond C 5% 105.8247 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 options. The benchmark bonds in Exhibit 2 pay coupons annually, and the bonds are priced at par. Exhibit 2 Benchmark Par Curve Maturity (years) Yield to Maturity (YTM) 1 3.0% 2 4.0% 3 5.0% Tatton then identifies three mispriced three- year annual- pay bonds and compiles data on the bonds (see Exhibit 3). Exhibit 3 Market Data of Annual- Pay Corporate Bonds Company Coupon Market Price Yield Embedded Option? Hutto- Barkley Inc. 3% 94.9984 5.6% No Luna y Estrellas Intl. 0% 88.8996 4.0% Yes Peaton Scorpio Motors 0% 83.9619 6.0% No

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