RJR Nabisco Holdings Capital Corp 1991 Case Solution

Case Solution

A great investment manager notices a substantial apparent discrepancy inside the prices of two nearly-identical bonds launched together with a substantial utilized buyout. The manager must determine whether the instruments are mis-indexed by compliance with one another, so when so, the best way to capture arbitrage profits within the temporary anomaly. The case introduces students to numerous instruments different from fairly simple treasury strips to P-I-K debentures. Encourages students to plot arbitrage positions and know the degree these positions are risk less.

Excel Calculations

Yes

Questions Covered

1.      What package of Discount Debentures and Treasury STRIPs would produce one "synthetic" 13.5% Debenture? On January 15, 1991, how much would it cost Ms. Samuels to buy the components of one synthetic 13.5% bond using Discount Debentures plus Treasury STRIPs?

2.      How will the synthetic 13.5% and the RJR 13.5% Debentures perform differently over time? You may want to consider factors including, but not limited to, how the two instruments are affected by interest rate changes, changes in RJR's credit rating, etc.

3.      How could Ms. Samuels profit from the relative mispricing of the RJR 13.5% Debenture and the Discount Debentures? What advice might she give to the following of her clients, each of whom does not pay any taxes?

a) Client A already owns the 13.5% RJR Debenture.

b) Client B does not own the 13.5% RJR Debenture.

Of what risks should Ms. Samuels advise her clients, if they follow her advice? Would you expect the relative prices to remain as they are on January 15, 1991? Why or why not? What will Ms. Samuels advise later if the relative prices of the 13.5% Debenture and the synthetic change dramatically? What might explain the relative pricing in January 1991 of the Discount Debentures and the 13.5% Debentures?

4.      At issue, do you think the three debentures were appropriately priced relative to treasuries and relative to one another? How do the specific terms of the instruments affect these relative prices? Why do you think RJR Nabisco chose to structure its debt using three terms? In November 1994, what would you expect the prices of the three debentures will be, relative to one another?