strips -separate trading of registered interest and principal securities” presented by group 5
TRANSCRIPT
STRIPS-Separate Trading of Registered Interest and
Principal Securities”
Presented by Group 5
Group Members
Aashish Lalpuria 34
Sachin Mundra 36
Sangeeta Ramdas 48
Prashant Sawant 51
Suraj Shetty 57
Anup Tripathi 59
Sachin Dsouza 63
Road Map
Introduction
Valuation of Strips.
YTM curve v Spot Curve
Characteristics of STRIPS.
A Case Study.
Indian Scenario.
Conclusion
Introduction
An Acronym for Separate Trading of Registered Interest & Principal Securities
Process of converting periodic coupon (Interest) payments and the principal of an existing government security into tradable zero coupon securities
• Program Introduced in February 1985
• Fixed Income Products created by Investment Banks
• Structure of STRIPS
• Coupon STRIPS (IO)
• Principal STRIPS (PO)
3 Year Treasury Note
Synthesize
Par Value of Bond
Cash Flow 2 Interest
Cash Flow 3 Interest
Cash Flow 4 Interest
Cash Flow 5 Interest
Cash Flow 1 Interest
Cash Flow 6 Interest
Principal
Strip
(P-Strip)
Coupon Strips
(C-Strips)
Formulae
Discounting Cash Flows to Present Values
P= C1 + C2 + C3 + C4…………………. + Cn-1 + Cn …………. (1)
(1+r1)1 (1+r2)2 (1+r3)3 (1+r4)4 (1+rn-1)n-1 (1+rn)n
Where,
C = is the semi-annual coupon that the bond pays from 1-n periods.
r1, r2, r3....rn= Discounting formula includes variable rates which is the spot rates of
the zero coupon bonds corresponding to the maturities of the cash flows.
We use the treasury prices to derive the implied spot interest rates.
Valuation Of Strips
Ten Hypothetical Treasuries
T-Bills Maturity TTM Coupon (%) Semi annualYTM Price Spot Rate spot rate (s.a)
1 9/ 1/ 1999 0.50 5.0 6.00 99.5146 6.000 3.000%
2 3/ 1/ 2000 1.00 10.0 6.30 103.5322 6.307 3.154%
3 9/ 1/ 2000 1.50 7.0 6.40 100.8453 6.407 3.203%
4 3/ 1/ 2001 2.00 6.5 6.70 99.6314 6.720 3.360%
5 9/ 1/ 2001 2.50 8.0 6.90 102.4868 6.936 3.468%
6 3/ 1/ 2002 3.00 10.5 7.30 108.4838 7.394 3.697%
7 9/ 1/ 2002 3.50 9.0 7.60 104.2327 7.712 3.856%
8 3/ 1/ 2003 4.00 7.3 7.80 98.1408 7.966 3.983%
9 9/ 1/ 2003 4.50 7.5 7.95 98.3215 8.076 4.038%
10 3/ 1/ 2004 5.00 8.0 8.00 100.0000 8.128 4.064%
Stripping coupon treasuries allows implied zero-coupon rates (spot rates) to be calculated.
Spot rates can then be compared with actual strip market yields.
Case Study:
Settlement date: 1st March 1999 (No Accrued Interest)
Assumptions: Yield curve is positive
Condition
Principle of No- Arbitrage pricing requires the price of the 1-year treasury strip equal the sum of present value of the coupon treasuries two cash flows
1 2Cash FlowsTreasury Note
6 Months
1 Year
1 Year
Treasury Strip
Sum of Price present value of Cash flows= Price of present value of T- Strip
Method
The first bond is a zero-coupon bond and its yield of 6% can be taken as the 6-month spot rate.
use the 6-month spot rate to find the 1-year spot rate using the 1-year bond
Cash Flows:
September 1st 1999 Rs. 5
March 1st 2000 Rs. 5 + Rs.100 = Rs.105
Discounting Cash Flow to present value(using formula 1):
103.5322 = 5 + 105
(1+.6/2)1 (1+r2)2
Where,
r1 : Theoretical 6-month spot rate (semi-annual)
r2: Theoretical 1-year spot rate (semi- annual)
Multiply by 2- r2= 6.307%.
Use the 6-month and 1-yr spot rate to calculate 1.5 yr theoretical spot rate(Repeat Process for all).
YTM Curve Vs Spot Rate Curve
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
9.00
0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00
Term To Maturity (yrs)
Yie
ld (%)YTM Curve Spot Rate
Yield Analysis
Positive Yield Curve:
1. Spot curve lies above YTM curve except at shortest rate which is the 6-month interest rate.
2. Difference between the two curves increases as maturity increases.
Actual Discounted rates are complicated averages of spot rates and averaging dampens volatility, YTM curve will be flatter to the spot curve.
Exception: when bond curve is flat, so is spot rate. They become identical.
Negative yield curve:
1. YTM curve lies above spot rate curve, rates discounting the coupon bonds earlier cash flows are higher than rate discounting their final payments at redemption.
2.Spreads between the spot rate and actual rates should decrease with maturity.
U.S Govt. Strip Market
012345
3 MO
1YR
3YR
5YR
7YR
9YR
15YR
30YR
Spot
Rat
e (
%)
Term To Maturity
U.S Govt T-Strips Yield Curve
U.S Govt T-Strips Yield Curve
Characteristics Of Strips/ Hypotheses
Treasury Strips have no Reinvestment risk
Principal strips trade at a premium to coupon strips:
The larger amount (P-Strip) results in greater liquidity
Principal strips trades expensive relative to their theoretical values:
Above anomaly
Strips with longest maturities are the most expensive:
Longer duration and greater convexity
Intermediate maturity coupons are cheaper relative to the curve:
Parity principal based on the Law of one price
Characteristics Of Strips/ Hypotheses (Cont.d)
Treasury strips with short maturity are well bid on
When yield curve is positive, strips are often in demand because investors match liabilities without investment risk and at a higher yield(spot curve lies above YTM Curve) than they could get on coupon bonds of the same maturity
Exception: U.S T-strips -> inverted yield curve
Fungibility -Coupon strips of the same dates but of different bonds are exchangeable (does not make them identical).
Strips have higher duration and price sensitivity:
Higher Duration implies Strips may be more sensitive to interest rate movements compared to coupon bonds.
Strips carry interest rate risk and inflation risk
Arbitrage (strip maker)
If market price of treasury security is valued lower using the spot rate approach
Then,
Method:
The potential profit of stripping a treasury depends on its current market treasury yields and its implied spot rate
Buy the treasury security and strip it
Sell the Strips it for higher value than cost of purchasing
treasury security
Case Study (Continued)
Example:
T 4 1999/04/05 U.S T-note:
Table shows:
1. Present values(5th Column) of the bond’s cash flows discounted with market interest rate, Present values represents the price paid for the treasury(entire package), at market yield of 8% (4% semi-annual)
2. Present values(6th Column) of treasury strips each discounted with observed market yield to maturity
Difference in present values leaves an opportunity for arbitrageT-Bills Maturity DateTTM Cash Flow PV at 8% YTM (%) PV at YTM PV8%-PV YTM
1 9/ 1/ 1999 0.50 4.0 3.8461538 6.00 3.8834951 0.0373413
2 3/ 1/ 2000 1.00 4.0 3.6982249 6.30 3.7594259 0.0612010
3 9/ 1/ 2000 1.50 4.0 3.5559854 6.40 3.6393255 0.0833401
4 3/ 1/ 2001 2.00 4.0 3.4192168 6.70 3.5060497 0.0868329
5 9/ 1/ 2001 2.50 4.0 3.2877084 6.90 3.3760395 0.0883311
6 3/ 1/ 2002 3.00 4.0 3.1612581 7.30 3.2258499 0.0645918
7 9/ 1/ 2002 3.50 4.0 3.0396713 7.60 3.0809065 0.0412352
8 3/ 1/ 2003 4.00 4.0 2.9227608 7.80 2.9453412 0.0225804
9 9/ 1/ 2003 4.50 4.0 2.8103469 7.95 2.8164343 0.0060874
10 3/ 1/ 2004 5.00 104.0 70.258674 8.00 70.258674 0.0000000
Total 100.00 100.49154
Case Study (Continued)
Calculation:
For instance the $ 4 coupon payment in 5 years $ 3.2877, investors are willing to accept lower yield on payment of the 5 year strip of the treasury 6.90% (3.30% semi-annual).
Sell strip for $ 3.376
Profit= $.0883 per $100
Strip U.S T-Note
Calculate PV of Cash Flows at
Coupon Rate
Calculate PV of Cash Flows at
YTM
Buy U.S T-NOTE
∑PV at 8%>∑PV at YTM ≠ 0, Therefore Arbitrage Profit
Reconstitution
If observed market yield of treasury strips are higher than yield of the treasury bond
Then,
Method:
Reconstitution:
involves assembling parts of treasury strips such that a new whole treasury coupon bond with same cash flows is created (Fungibility),
i.e. create an artificial treasury coupon security cheaper than the same maturity and coupon treasury issue.
Difference would be the arbitrage profit.
If the market yields of the treasury strips were the theoretical spot rates the present value would approximately equal $100, no arbitrage profit is possible.
Reconstitution (Continued)
C-Strip
C-Strip
C-Strip
C-Strip
C-Strip
P-Strip
Coupon
Bond
Case Study: Reconstitution
Table shows:
1. Present values(5th Column) of the bond’s cash flows discounted with market interest rate, Present values represents the price paid for the treasury(entire package), at market yield of 8% (4% semi-annual)
2. Present values(6th Column) of treasury strips each discounted with observed market yield to maturity
Difference in present values leaves an opportunity for arbitrage
T-Bills Maturity TTM Cash Flow PV at 9% YTM (%) PV at YTM PV9%-PV YTM
1 9/ 1/ 1999 0.50 4.0 3.8461538 6.00 3.88350 0.0373413
2 3/ 1/ 2000 1.00 4.0 3.6982249 6.70 3.74489 0.0466648
3 9/ 1/ 2000 1.50 4.0 3.5559854 6.90 3.61300 0.0570191
4 3/ 1/ 2001 2.00 4.0 3.4192168 7.10 3.47904 0.0598245
5 9/ 1/ 2001 2.50 4.0 3.2877084 7.60 3.31950 0.0317958
6 3/ 1/ 2002 3.00 4.0 3.1612581 8.10 3.15215 -0.0091037
7 9/ 1/ 2002 3.50 4.0 3.0396713 8.60 2.97900 -0.0606759
8 3/ 1/ 2003 4.00 4.0 2.9227608 8.80 2.83437 -0.0883943
9 9/ 1/ 2003 4.50 4.0 2.8103469 8.85 2.70907 -0.1012806
10 3/ 1/ 2004 5.00 104.0 70.258674 9.00 66.96848 -3.2901946
Total 100.00 96.68300
Case Study: Reconstitution (Continued)
Calculation:
For instance the $ 4 coupon payment in 5 years $ 3.2877, investors are un-willing to accept higher yield on payment of the 5 year strip of the treasury 7.60% (6.60% semi-annual).
Buy strip for $ 3.3195
Similarly compile coupon strips, including P-strip of similar cash flows
Profit= (Sale of reconstituted (whole) coupon bond) = $3.3170 per $100
Reconstitute
Calculate PV of Cash Flows at
Coupon Rate
Calculate PV of Cash Flows at
YTM
Buy U.S T-Strips
∑PV at 8%<∑PV at YTM ≠ 0, Therefore Arbitrage Profit
Indian Strip Market Preliminary report
PDs will act as market makers
Stripping and reconstitution to be done through PDO-NDS
Minimum amount of securities to be stripped or reconstituted should be INR 1 crore (face value) and multiples thereof
Tradable only in the OTC market
Clearing and settlement through CCIL
Indian Strip Market Preliminary report (Banks)
Will be recognized for SLR purpose
Investments in HTM (Held to Maturity) should not exceed more than 25% of investments for banks
HTF (Held for Trading) should be sold within 90 days
Indian Strip Market Preliminary report (Income Tax)
Taxable every year by using Mark to market method
If acquired during the year then treat the difference between Market Value (as on 31st March) and Cost (at which the security was acquired) as his Interest Income liable for taxation
If transferred before maturity, the seller to treat the difference as Capital Gains liable for taxation
Conclusion
STRIPS will provide:
A surplus of zero coupon bonds into the market.
Advantage of having the most basic cash flow structure offers a more accurate match to liabilities without the reinvestment risk with precise number of cash flows.
Apart from the lower risk, strips offer greater leverage to hedge funds, as the zero coupon bonds are more volatile than its underlying coupon bearing bonds.
Even though developed markets rarely see opportunities for arbitrage. India will be a new undertaker of this debt instrument.
If implementation successfully occurs India, with newly issued treasury strips, the market instrument would tend to become uncertain, resulting with erratic supply/demand. There would then, in this case be a chance to profit from this.
Bibliography
http://www.treasurydirect.gov/instit/marketables/strips/strips.htm
http://www.treasurydirect.gov/govt/reports/pd/pd.htm
http://stripbonds.info/
http://www.investopedia.com/articles/bonds/
http://www.streetauthority.com/terms/s/strips.asp
http://www.rbi.org