Description
The PPT explaining Separate Trading of Registered Interest and Principal of Securities (STRIPS)
STRIPS
AGENDA
?Introducion
?STRIPS
?Bootstrapping
?Adantages & Disadvantages
?Why use STRIPS
?Arbitrage opportunities
?STRIPS in India
?References
INTRODUCTION
• Stands for Separate Trading of Registered
Interest and Principal of Securities.
• STRIPS are zero-coupon securities ("zeros").
Because the U.S. Treasury does not issue zeros
directly, STRIPS give investors a way to access
long-term zero-coupon instruments that have no
credit risk.
• A zero coupon carries no reinvestment risk, has
predictable cash flow and is more volatile
STRIPS
? The minimum face value of a stripped payment
(such as a single coupon payment) is $1,000.
? Thus the par amount must be large enough to yield
a semi-annual payment amount of $1,000 (or
multiples of $1,000).
? About 33% of all outstanding T-bonds are stripped.
CUSIP
? Each payment will be given its own CUSIP
(Committee on Uniform Security Identification
Procedures) number.
? The first six characters are known as the base (or
CUSIP-6), and uniquely identify the issuer.
? The 7th and 8th digit identify the exact issue.
? The 9th digit is an automatically generated
checksum
? Eg. Apple Inc: 037833100
U.S. TREASURY STRIPS
? An asked yield for a U.S. Treasury STRIP is an
APR, calculated as two times the true semiannual
rate.
? Recall:
? Therefore, for STRIPS
( )
N
r 1
value Future
value Present
+
=
( )
2M
2
YTM
1
Value Face
Price STRIPS
+
=
M is the number of years to maturity.
U.S. TREASURY STRIPS
EXAMPLE: PRICING U.S. TREASURY STRIPS,
I.
? Let’s verify the price of the May 2013 Strip.
? The ask quote is 68:24, or $68.75.
? The ask YTM is 3.79%.
? Matures in about 10 years from the time of the quote
( ) ( )
( )
$68.70.
1.4556
100
2
0.0379
1
100
2
0.0379
1
100
2
YTM
1
Value Face
Price STRIPS
10 2
10 2 2M
= =
+
=
+
=
+
=
×
×
EXAMPLE: PRICING U.S. TREASURY STRIPS,
II.
? Let’s calculate the YTM from the quoted price.
( ) | | 3.78%. or 0.037823, 1 1.454545 2
1
68.75
100
2 1
Price STRIPS
Value Face
2 YTM
0.05
10 2
1
2M
1
= ÷ × =
(
(
¸
(
¸
÷
|
.
|
\
|
× =
(
(
(
¸
(
¸
÷
|
|
.
|
\
|
× =
×
BOOTSTRAPPING
Objective
? To construct a spot rate term structure and hence
calculate the PV of the Coupon and Principal Strips
BOOTSTRAPPING
Example
? Calculate the Spot Rate Curve for the next 2 years
? For 0.5 yr
FV = PV*e
r*t
100 = 97.5*e
r*0.5
Solving for r
0.5
= 5.06%
? For 1yr
FV = PV*e
r*t
100 = 94.5*e
r*1
Solving for r
1.0
= 5.65%
Years to Maturity 0.25 0.5 1.0 1.5 2.0
Bond price (PV) $99.00 $97.50 $94.50 $98.00 $102.00
Coupon rate 0.00% 0.00% 0.00% 8.00% 12.00%
BOOTSTRAPPING
? T-Note 1.5 yrs
? 98 = 4*e
-r
0.5
*0.5
+ 4*e
-r
1.0
*1
+ 104*e
-r
1.5
*1.5
? r
1.5
= 9.40%
? T-Note 2yrs
? 102 = 6*e
-r
0.5
*0.5
+ 6*e
-r
1.0
*1
+ 6*e
-r
1.5
*1.5
+ 106*e
-
r
2.0
*2.0
? r
2.0
= 10.88%
Years to Maturity 0.25 0.5 1.0 1.5 2.0
Bond price (PV) $99.00 $97.50 $94.50 $98.00 $102.00
Coupon rate 0.00% 0.00% 0.00% 8.00% 12.00%
BOOTSTRAPPING
BOOTSTRAPPING
? Consider T-Note maturing in 2 yrs
? Coupon = 15%
ci ci ci ci np
7.5 7.5 7.5 7.5 100
7.31 7.09 6.51 6.03 80.44
PV 107.39
ADVANTAGES OF STRIPS
? Strip Bonds are available in a variety of maturity
dates that makes it easy to match your specific
investment needs.
? Advantage of more accurate matching of liabilities
without re investment risk and more effective cash
flow management.
? More volatility: offer greater leverage to Hedge
funds.
? Attracting retail investors to trading in strips which
would result in broad-basing the government
securities
ADVANTAGES (CONTD.)
? Arbitrage opportunities: if the sum of values of the
constituent parts exceed the value of the whole
bond.
? STRIPS add to the menu of investment avenues
presently available to the market.
? Leads to fair valuation towards Zero Coupon
Valuation Method.
DISADVANTAGES
? Price of STRIPS is more volatile than ordinary
bonds. i.e when interest rates rise or falls price of
STRIP will change on a greater extent.
? Because the market for strip bonds can be illiquid.
? If you sell before maturity, you may have a capital
loss, depending on market conditions at the time
DISADVANTAGES (CONTD.)
? Tax laws may require that you pay taxes related to
the hypothetical interest or gain each year, even if
you did not receive an actual cash payment
? Because many strip bonds have a long time
horizon, there could be unforeseen changes that
adversely affect your investment (e.g., changes in
tax laws, issuer credit rating, etc.)
? Squeezes both the cash and repo markets
ARBITRAGE IN STRIPS
• Preferred Habitat Theory
– Premiums related to supply & demand
– Funds at maturities, not the terms to maturity
• Which has more demand:
– Part of the sum or sum of the part
• 2 Factors determine STRIPS price:
– 1. Demand & Supply
– 2. Volume
STRIPPING & RECONSTITUTING
• Portfolio of STRIPS > Underlying bond
• Underlying bond > Portfolio of STRIPS
• Implication:
?P
i,t
=(P
bid
cash ?P
bid
STRIPS)
i,t
=0
P
cash
is the full or invoice price
P
STRIPS
is the price of the corresponding portfolio
• Arbitrage if any of these 2 conditions violated:
• (?
S
)
i,t
=(P
bid
STRIPS ?P
ask
cash)
i,t
?1/ 256 ?0;
• (?
R
)
i,t
=(P
bid
cash ?P
ask
STRIPS )
i,t
?1/ 256 ?0
EXAMPLE
? ?P=(99.762228 ?99.76533) =?.003102
? Arbitrage of 0.3 cents
?(?
S
) =(99.76533?99.793478) ?1/ 256 =
?.03205425
? Arbitrage of 3.2 cents
?(?
R
) =(99.762228 ?99.79298) ?1/ 256 =
?.03465825
? Arbitrage of 3.4 cents
Reconstitution of the 4 ½ percent coupon U.S.
Treasury note maturing November 15, 2007 as of
the market close on Wednesday August 15, 2007
STRIPS STRIPS Bid Bid ASKED ASKED
Maturity Type Amount Price Amount Price Amount
Nov 15 2007 ci 2.2500 98.9560 2.2265 98.9760 2.2270
May 15 2008 ci 2.2500 96.7310 2.1764 96.7510 2.1769
Nov 15 2008 ci 2.2500 94.6520 2.1297 94.6720 2.1301
May 15 2009 ci 2.2500 92.8970 2.0901 92.9170 2.0906
Nov 15 2009 ci 2.2500 90.9100 2.9455 90.9300 2.0459
May 15 2010 ci 2.2500 88.8780 1.9998 88.8980 2.0002
Nov 15 2010 ci 2.2500 87.1640 1.9612 87.1840 1.9616
May 15 2011 ci 2.2500 85.7940 1.9304 85.8140 1.9308
Nov 15 2011 ci 2.2500 84.8080 1.9082 84.8280 1.9086
May 15 2012 ci 2.2500 82.2220 1.8500 82.2420 1.8504
Nov 15 2012 ci 2.2500 79.4560 1.7878 79.4760 1.7882
May 15 2013 ci 2.2500 77.1630 1.7362 77.1830 1.7366
Nov 15 2013 ci 2.2500 75.2640 1.6934 75.2840 1.6939
May 15 2014 ci 2.2500 73.2690 1.6486 73.2890 1.6490
Nov 15 2014 ci 2.2500 71.4720 1.6081 71.4920 1.6086
May 15 2015 ci 2.2500 69.5580 1.5651 69.5780 1.5655
Nov 15 2015 ci 2.2500 67.5760 1.4755 67.5960 1.5209
Nov 15 2015 np 100.0000 67.8880 67.8880 67.9080 67.9080
Total 99.7653 99.7930
ci = coupon interest and np = note principal
POSSIBLE EXPLANATIONS
? Historically demand for long maturity principal
strong
? Reconstitute strips and coupons at different points
? Imbalance between the prices of the underlying
coupon bearing stock and the sum of the prices
? STRIPS provide higher leverage
? Tracking theoretical spreads
REALITY
? Arbitrage very rare
? Transaction costs
? Income tax
? Market equilibrium
STRIPS IN INDIA
- Underdeveloped Bond Market
?Policy issues
?Presence of “Development Finance
Institutions”
- Issue of ZCB by the issuers themselves
STRIPS IN INDIA
IT Act
? Doesn’t permit transfer of only a part of the amount appearing
to be due on an instrument
Tax Laws
? On Maturity
? Premature exit
REMEDIAL STEPS
• Act modified - stripping of a normal interest bearing
bond into its components will not amount to a
transfer, neither does reconstitution
• Tax laws modified to remove the fear of bunching
effect during redemption.
– tax the difference in value from previous year as
interest.
ROAD AHEAD
• Consolidation of loans
– RBI is consolidating outstanding gilts to ensure sufficient
volumes and liquidity in any one issue
• Fungibility
– Neither Principal/ Principal nor Principal/ Interest strips
may be made fungible.
– Coupon strips derived from two different strippable
securities may be made fungible with each other, provided
they have same coupon rate and coupon maturity.
• Alignment of coupon dates (in future)
– RBI is announcing a calendar for issue of treasury bills for
a whole year.
ROAD AHEAD
? Selection Criteria for security stripping
? Generation of sufficient rupee volume, for each
redemption date, in the resulting coupon and principal
strips
? Coupon dates evenly spread out
? Maturity range
? Liquid or not
? Coupon date pairs
REFERENCES
? http://stripbonds.info/
? Wikipedia
? Fixed Income Analysis - Frank Fabozzi
? http://rbidocs.rbi.org.in/
? http://www.open-ira.com/
? Fixed Income Securities 2nd Edition
[Bruce Tuckman]
? John Hull options futures and other derivatives
? www.abe.sju.edu/proc2008/cole.pdf
? http://www.bionicturtle.com/
? CFA Level 1 Notes
THANK YOU
doc_559146251.ppt
The PPT explaining Separate Trading of Registered Interest and Principal of Securities (STRIPS)
STRIPS
AGENDA
?Introducion
?STRIPS
?Bootstrapping
?Adantages & Disadvantages
?Why use STRIPS
?Arbitrage opportunities
?STRIPS in India
?References
INTRODUCTION
• Stands for Separate Trading of Registered
Interest and Principal of Securities.
• STRIPS are zero-coupon securities ("zeros").
Because the U.S. Treasury does not issue zeros
directly, STRIPS give investors a way to access
long-term zero-coupon instruments that have no
credit risk.
• A zero coupon carries no reinvestment risk, has
predictable cash flow and is more volatile
STRIPS
? The minimum face value of a stripped payment
(such as a single coupon payment) is $1,000.
? Thus the par amount must be large enough to yield
a semi-annual payment amount of $1,000 (or
multiples of $1,000).
? About 33% of all outstanding T-bonds are stripped.
CUSIP
? Each payment will be given its own CUSIP
(Committee on Uniform Security Identification
Procedures) number.
? The first six characters are known as the base (or
CUSIP-6), and uniquely identify the issuer.
? The 7th and 8th digit identify the exact issue.
? The 9th digit is an automatically generated
checksum
? Eg. Apple Inc: 037833100
U.S. TREASURY STRIPS
? An asked yield for a U.S. Treasury STRIP is an
APR, calculated as two times the true semiannual
rate.
? Recall:
? Therefore, for STRIPS
( )
N
r 1
value Future
value Present
+
=
( )
2M
2
YTM
1
Value Face
Price STRIPS
+
=
M is the number of years to maturity.
U.S. TREASURY STRIPS
EXAMPLE: PRICING U.S. TREASURY STRIPS,
I.
? Let’s verify the price of the May 2013 Strip.
? The ask quote is 68:24, or $68.75.
? The ask YTM is 3.79%.
? Matures in about 10 years from the time of the quote
( ) ( )
( )
$68.70.
1.4556
100
2
0.0379
1
100
2
0.0379
1
100
2
YTM
1
Value Face
Price STRIPS
10 2
10 2 2M
= =
+
=
+
=
+
=
×
×
EXAMPLE: PRICING U.S. TREASURY STRIPS,
II.
? Let’s calculate the YTM from the quoted price.
( ) | | 3.78%. or 0.037823, 1 1.454545 2
1
68.75
100
2 1
Price STRIPS
Value Face
2 YTM
0.05
10 2
1
2M
1
= ÷ × =
(
(
¸
(
¸
÷
|
.
|
\
|
× =
(
(
(
¸
(
¸
÷
|
|
.
|
\
|
× =
×
BOOTSTRAPPING
Objective
? To construct a spot rate term structure and hence
calculate the PV of the Coupon and Principal Strips
BOOTSTRAPPING
Example
? Calculate the Spot Rate Curve for the next 2 years
? For 0.5 yr
FV = PV*e
r*t
100 = 97.5*e
r*0.5
Solving for r
0.5
= 5.06%
? For 1yr
FV = PV*e
r*t
100 = 94.5*e
r*1
Solving for r
1.0
= 5.65%
Years to Maturity 0.25 0.5 1.0 1.5 2.0
Bond price (PV) $99.00 $97.50 $94.50 $98.00 $102.00
Coupon rate 0.00% 0.00% 0.00% 8.00% 12.00%
BOOTSTRAPPING
? T-Note 1.5 yrs
? 98 = 4*e
-r
0.5
*0.5
+ 4*e
-r
1.0
*1
+ 104*e
-r
1.5
*1.5
? r
1.5
= 9.40%
? T-Note 2yrs
? 102 = 6*e
-r
0.5
*0.5
+ 6*e
-r
1.0
*1
+ 6*e
-r
1.5
*1.5
+ 106*e
-
r
2.0
*2.0
? r
2.0
= 10.88%
Years to Maturity 0.25 0.5 1.0 1.5 2.0
Bond price (PV) $99.00 $97.50 $94.50 $98.00 $102.00
Coupon rate 0.00% 0.00% 0.00% 8.00% 12.00%
BOOTSTRAPPING
BOOTSTRAPPING
? Consider T-Note maturing in 2 yrs
? Coupon = 15%
ci ci ci ci np
7.5 7.5 7.5 7.5 100
7.31 7.09 6.51 6.03 80.44
PV 107.39
ADVANTAGES OF STRIPS
? Strip Bonds are available in a variety of maturity
dates that makes it easy to match your specific
investment needs.
? Advantage of more accurate matching of liabilities
without re investment risk and more effective cash
flow management.
? More volatility: offer greater leverage to Hedge
funds.
? Attracting retail investors to trading in strips which
would result in broad-basing the government
securities
ADVANTAGES (CONTD.)
? Arbitrage opportunities: if the sum of values of the
constituent parts exceed the value of the whole
bond.
? STRIPS add to the menu of investment avenues
presently available to the market.
? Leads to fair valuation towards Zero Coupon
Valuation Method.
DISADVANTAGES
? Price of STRIPS is more volatile than ordinary
bonds. i.e when interest rates rise or falls price of
STRIP will change on a greater extent.
? Because the market for strip bonds can be illiquid.
? If you sell before maturity, you may have a capital
loss, depending on market conditions at the time
DISADVANTAGES (CONTD.)
? Tax laws may require that you pay taxes related to
the hypothetical interest or gain each year, even if
you did not receive an actual cash payment
? Because many strip bonds have a long time
horizon, there could be unforeseen changes that
adversely affect your investment (e.g., changes in
tax laws, issuer credit rating, etc.)
? Squeezes both the cash and repo markets
ARBITRAGE IN STRIPS
• Preferred Habitat Theory
– Premiums related to supply & demand
– Funds at maturities, not the terms to maturity
• Which has more demand:
– Part of the sum or sum of the part
• 2 Factors determine STRIPS price:
– 1. Demand & Supply
– 2. Volume
STRIPPING & RECONSTITUTING
• Portfolio of STRIPS > Underlying bond
• Underlying bond > Portfolio of STRIPS
• Implication:
?P
i,t
=(P
bid
cash ?P
bid
STRIPS)
i,t
=0
P
cash
is the full or invoice price
P
STRIPS
is the price of the corresponding portfolio
• Arbitrage if any of these 2 conditions violated:
• (?
S
)
i,t
=(P
bid
STRIPS ?P
ask
cash)
i,t
?1/ 256 ?0;
• (?
R
)
i,t
=(P
bid
cash ?P
ask
STRIPS )
i,t
?1/ 256 ?0
EXAMPLE
? ?P=(99.762228 ?99.76533) =?.003102
? Arbitrage of 0.3 cents
?(?
S
) =(99.76533?99.793478) ?1/ 256 =
?.03205425
? Arbitrage of 3.2 cents
?(?
R
) =(99.762228 ?99.79298) ?1/ 256 =
?.03465825
? Arbitrage of 3.4 cents
Reconstitution of the 4 ½ percent coupon U.S.
Treasury note maturing November 15, 2007 as of
the market close on Wednesday August 15, 2007
STRIPS STRIPS Bid Bid ASKED ASKED
Maturity Type Amount Price Amount Price Amount
Nov 15 2007 ci 2.2500 98.9560 2.2265 98.9760 2.2270
May 15 2008 ci 2.2500 96.7310 2.1764 96.7510 2.1769
Nov 15 2008 ci 2.2500 94.6520 2.1297 94.6720 2.1301
May 15 2009 ci 2.2500 92.8970 2.0901 92.9170 2.0906
Nov 15 2009 ci 2.2500 90.9100 2.9455 90.9300 2.0459
May 15 2010 ci 2.2500 88.8780 1.9998 88.8980 2.0002
Nov 15 2010 ci 2.2500 87.1640 1.9612 87.1840 1.9616
May 15 2011 ci 2.2500 85.7940 1.9304 85.8140 1.9308
Nov 15 2011 ci 2.2500 84.8080 1.9082 84.8280 1.9086
May 15 2012 ci 2.2500 82.2220 1.8500 82.2420 1.8504
Nov 15 2012 ci 2.2500 79.4560 1.7878 79.4760 1.7882
May 15 2013 ci 2.2500 77.1630 1.7362 77.1830 1.7366
Nov 15 2013 ci 2.2500 75.2640 1.6934 75.2840 1.6939
May 15 2014 ci 2.2500 73.2690 1.6486 73.2890 1.6490
Nov 15 2014 ci 2.2500 71.4720 1.6081 71.4920 1.6086
May 15 2015 ci 2.2500 69.5580 1.5651 69.5780 1.5655
Nov 15 2015 ci 2.2500 67.5760 1.4755 67.5960 1.5209
Nov 15 2015 np 100.0000 67.8880 67.8880 67.9080 67.9080
Total 99.7653 99.7930
ci = coupon interest and np = note principal
POSSIBLE EXPLANATIONS
? Historically demand for long maturity principal
strong
? Reconstitute strips and coupons at different points
? Imbalance between the prices of the underlying
coupon bearing stock and the sum of the prices
? STRIPS provide higher leverage
? Tracking theoretical spreads
REALITY
? Arbitrage very rare
? Transaction costs
? Income tax
? Market equilibrium
STRIPS IN INDIA
- Underdeveloped Bond Market
?Policy issues
?Presence of “Development Finance
Institutions”
- Issue of ZCB by the issuers themselves
STRIPS IN INDIA
IT Act
? Doesn’t permit transfer of only a part of the amount appearing
to be due on an instrument
Tax Laws
? On Maturity
? Premature exit
REMEDIAL STEPS
• Act modified - stripping of a normal interest bearing
bond into its components will not amount to a
transfer, neither does reconstitution
• Tax laws modified to remove the fear of bunching
effect during redemption.
– tax the difference in value from previous year as
interest.
ROAD AHEAD
• Consolidation of loans
– RBI is consolidating outstanding gilts to ensure sufficient
volumes and liquidity in any one issue
• Fungibility
– Neither Principal/ Principal nor Principal/ Interest strips
may be made fungible.
– Coupon strips derived from two different strippable
securities may be made fungible with each other, provided
they have same coupon rate and coupon maturity.
• Alignment of coupon dates (in future)
– RBI is announcing a calendar for issue of treasury bills for
a whole year.
ROAD AHEAD
? Selection Criteria for security stripping
? Generation of sufficient rupee volume, for each
redemption date, in the resulting coupon and principal
strips
? Coupon dates evenly spread out
? Maturity range
? Liquid or not
? Coupon date pairs
REFERENCES
? http://stripbonds.info/
? Wikipedia
? Fixed Income Analysis - Frank Fabozzi
? http://rbidocs.rbi.org.in/
? http://www.open-ira.com/
? Fixed Income Securities 2nd Edition
[Bruce Tuckman]
? John Hull options futures and other derivatives
? www.abe.sju.edu/proc2008/cole.pdf
? http://www.bionicturtle.com/
? CFA Level 1 Notes
THANK YOU
doc_559146251.ppt