WHAT'S THE POINT? Some publisher got the idea I'd be interested in adopting Bond Markets, Analysis and Strategies. Unlikely, but the book gives me an idea what happens when the College of Deaducation and the Pointy Haired Boss team up to organize material. (Bleah.)

What prompts tonight's post, however, is something I read about in chapter 2. Take a holding of garden variety 30 year debentures yielding 7.5%. But don't hide 'em in the safe deposit except to clip coupons. Instead, underwrite some derivative securities. Use half of them as collateral for what the trade calls a "floater". Sell a bond that pays the 30 year Treasury rate (or anything else that you fancy) plus 1%. Use the other half as collateral for an "inverse floater". Sell another bond that pays the difference between 14% and the 30 year Treasury rate. Check the math: the convex combination of the two interest rates works to 7.5%. There's a continuum of convex combinations, and thus a continuum of other derivative assets to derive. The book doesn't get into them, although there's probably some hedge-fund hustler that knows the tricks forward and backward.

The example produces a bond that pays a higher interest rate than a Treasury, with comparable safety, and another bond that pays a junk bond return, but with greater safety. It's not quite a free lunch: the inverse is a residual claimant, with its price equal to the difference between the collateral's price (relatively easy to compute) and the floater's price (more challenging but not impossible).

The book doesn't tell me what the point of creating such a pair of securities is. Presumably there is some arbitrage opportunity in the different time paths of the prices of the securities that makes incurring the costs of issue worth bearing. Readers: any ideas?