Synthetic Callable Bond Construction course, create, should, asked, being

invic

As part of an HBS case study in an MBA level investments course, I am being asked to create a synthetic callable bond using non-callable bonds and STRIPs. The callable bond had a maturity date of 2005 and was first callable in 2000. It is an 8.25% coupon bond.

Supposedly I can create this callable bond synthetically by combining non-callable bonds maturing in 2005 with zero-coupon Treasuries (STRIPS) also maturing in 2005. According to my professor I should be able to match the cash flows of the callable bond by combining the non-callable and the STRIPS at fractions summing to one.

I am completely missing something in this problem, because I can't figure it out to save my life. If the callable bond is never called, then it should have the exact same cash flows as the non-callable bond correct? If that's the case then why do I need STRIPS to create a synthetic callable bond?

Any thoughts are much appreciated.

anish

Amazing. I just spent two hours trying to figure this out and only once I post to AF do I figure it out. Never mind but thank you to anyone who already read my post.

mp3bu

Sometimes posting a message forces you to articulate the problem clearly enough that it becomes easier to solve.

Seems to me that the answer must have some kind of dynamic adjustment between strips and noncallable credits of similar quality to simulate an interest rate call.

luckygiftvn

The answer was incredibly simplistic. I was just over-complicating the matter.

king_kong

Any chance you can post the answer or give a hint? You've piqued my interest and probably others'.

canadiananalyst

Dwight Wrote:
-------------------------------------------------------
> Any chance you can post the answer or give a hint?
> You've piqued my interest and probably others'.


+1

bpdulog

Libre27 Wrote:
-------------------------------------------------------
> The answer was incredibly simplistic. I was just
> over-complicating the matter.


Awesome. Can you help get us out of the economic crisis now? ;-)

Analyze_This

Buy a non-callable bond and sell the covered call, invest the difference of premium and funding in STRIPS at each interest payout period to match up to the yield of callable-bond.