i read it on Stalla’s Fixed-Income study guide and i didnt understand it, could someone please offer me a human language definition plus a numerical example to further comprehened it??!!
A treasury coupon bond cash flows are coupon interest and principal repayment. For example, think of a 10 year bond, semiannual coupon payments of 8%. The cash flows for this bond are 20 payments of $40, and one payment of $1000. The strips program allows you to sell the 21 cash flows separately (20 interest and one principal) in the market. Because each cash flow is now only a single cash flow to be received some time in the future, we now have 21 zero coupon bonds, each with a different maturity. Coupon strips will have a slightly different yield from principal strips, as principal strips are treated more favourably than coupon strips for some foreign investors. Arbitrage pricing theory states that the price of the cash flows and the price of the original bond (exact same cash flows, as one is simply separated and one is packaged together) must equal. Hope that makes sense.
Nalzaki, This can definitely be confusing. You can discount bond cash flows at the maturity yield, par yield, and spot rate. Using the spot rate is the correct, arbitrage free valuation approach. core-models.com has a very good model that explains why we use the spot rate to value bonds if your interested. It’s a good idea to know the meaning behind the calculations.
thanks guys much clearer now…
just one more question what would be the price of the 21 zero coupon bonds now?! they have to be discounted by the appropriate spot rate, right?! and they are not supposed to be equal in value, correct?! an example from the study guide: suppose 2-year 5% coupon treasury note is priced at $95 which is below its arbitrage-free value of $99.66. what action should the arbitrageurs take? answer: - bying the undervalued note at$95 - stripping the note of its individual cash flows - selling the individual cash flow "pieces"as zero coupon bonds for $99.66 and earning an arbitrage profit of $4.66 per $100 of investment. so the proceeds from selling the strips(coupon and principal) should be 99.66?!
Correct. Each strip is discounted at the spot rate for that particular maturity. In this case, arbitrage will force the price upward, until it’s around 99.66. If the price of the strips was $95, and the price of the bond is 99.66, then people will buy the strips, combine them, and sell the bond (called a synthetic bond), for 99.66.
great thanks for the help man…
A buddy of mine and I were discussing STRIPS this morning and I have a question: I understand how STRIPS work, etc. However, the question is, where does the money come from to pay the par, $1,000, at maturity for each STRIP? Take for example–a 5-year Treasury with a 5% coupon. The total payments over the life of the bond are 1-$1000 and 10-$25 payments, for a total of $1,250. If these are stripped, they will trade at a deep discount, based upon spot rates, however, if 11 of us front money to buy all the STRIPS, where does the $11,000 come from at maturity that is paid back???
soxboys21 Wrote: ------------------------------------------------------- > A buddy of mine and I were discussing STRIPS this > morning and I have a question: > > I understand how STRIPS work, etc. > > However, the question is, where does the money > come from to pay the par, $1,000, at maturity for > each STRIP? > > Take for example–a 5-year Treasury with a 5% > coupon. The total payments over the life of the > bond are 1-$1000 and 10-$25 payments, for a total > of $1,250. > > If these are stripped, they will trade at a deep > discount, based upon spot rates, however, if 11 of > us front money to buy all the STRIPS, where does > the $11,000 come from at maturity that is paid > back??? you got it a little bit wrong i think. for the bond you described you can make 11 zero coupon bonds by stripping. 10 ZC bonds with FV 25 (Each with different maturity which is understandable coz the coupons were actually expected every 6 months) 1 ZC with FV 1000 (5 year maturity) Discount Rate would be unchanged
I believe your statement about price is incorrect. Check CUSIP: 912833KC3 That is the STRIP INTEREST PMT of 05/15/2014 and it’s trading at a price of 87.66