We derive and investigate empirically arbitrage pricing restrictions among three bonds of RJR Nabisco Holdings Capital Corporation. The three RJR bonds are virtually identical in all respects, except for the form in which interest is paid. We document large and persistent errors in the market pricing of the three bonds over a two-year period. The cash-paying bond was consistently more expensive than either the pay-in-kind or deferred-coupon bonds. The magnitude of the pricing errors is too large to be explained by market imperfections.

ABSTRACT GNMA mortgage‐backed pass‐through securities are supported by pools of amortizing, callable loans. Additionally, mortgagors often prepay their loans when the market interest rate is above the coupon rate of their loans. This paper develops a model for pricing GNMA securities and uses it to examine the impact of the amortization, call, and prepayment features on the prices, risks and expected returns of GNMA's. The amortization and prepayment features each have a positive effect on price, while the call feature has a negative impact. All three features reduce a GNMA security's interest rate risk and, consequently, its expected return.