EBK INVESTMENTS
EBK INVESTMENTS
11th Edition
ISBN: 9781259357480
Author: Bodie
Publisher: MCGRAW HILL BOOK COMPANY
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Chapter 23, Problem 4PS
Summary Introduction

To explain: Method to earn profit in municipal bonds and T-bonds when the spread between these two is going to be narrow in the upcoming month.

Introduction: Bonds are the investment of the money. Municipal bonds are those bonds which are free from the taxes. T-bonds are the fixed bonds which gives high returns.

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You believe that the spread between municipal bond yields and U.S. Treasury bond yields is going to narrow in the coming month. How can you profit from such a change using the municipal bond and T-bond futures contracts?
PIMCO gives the following example of an Inflation Linked Bond (ILB), called a Treasury Inflation Protected Security (TIPS) in the US. "How do ILBs work? An ILB’s explicit link to a nationally-recognized inflation measure means that any increase in price levels directly translates into higher principal values. As a hypothetical example, consider a $1,000 20-year U.S. TIPS with a 2.5% coupon (1.25% on semiannual basis), and an inflation rate of 4%. The principal on the TIPS note will adjust upward on a daily basis to account for the 4% inflation rate. At maturity, the principal value will be $2,208 (4% per year, compounded semiannually). Additionally, while the coupon rate remains fixed at 2.5%, the dollar value of each interest payment will rise, as the coupon will be paid on the inflation-adjusted principal value. The first semiannual coupon of 1.25% paid on the inflation-adjusted principal of $1,020 is $12.75, while the final semiannual interest payment will be 1.25% of $2,208, which…
In the United States. The date is 26 July 2022. You decidethat the market has under-estimated the yield on long term Treasurybonds. You observe the following bond (in the picture). Describe how you would use this bond to trade in order to profit from your beliefs.
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