1. STRIPS -Separate Trading of Registered Interest and Principal Securities” Presented by Group 5

2. Group Members Aashish Lalpuria 34 Sachin Mundra 36 Sangeeta Ramdas 48 Prashant Sawant 51 Suraj Shetty 57 Anup Tripathi 59 Sachin Dsouza 63

3. Road Map Introduction Valuation of Strips. YTM curve v Spot Curve Characteristics of STRIPS. A Case Study. Indian Scenario. Conclusion

4. 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)

6. Formulae Discounting Cash Flows to Present Values P= C 1 + C 2 + C 3 + C 4 …………………. + C n-1 + C n …………. (1) (1+r 1 ) 1 (1+r 2 ) 2 (1+r 3 ) 3 (1+r 4 ) 4 (1+r n-1 ) n-1 (1+r n ) n Where, C = is the semi-annual coupon that the bond pays from 1-n periods. r 1, r 2, r 3....r n = 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.

7. Valuation Of Strips 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

8. 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 12Cash Flows Treasury Note 6 Months 1 Year Treasury Strip Sum of Price present value of Cash flows= Price of present value of T- Strip

9. 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+r 2 ) 2 Where, r 1 : Theoretical 6-month spot rate (semi-annual) r 2 : Theoretical 1-year spot rate (semi- annual) Multiply by 2- r 2 = 6.307%. Use the 6-month and 1-yr spot rate to calculate 1.5 yr theoretical spot rate(Repeat Process for all).

10. YTM Curve Vs Spot Rate Curve

11. 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.

12. U.S Govt. Strip Market

13. 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

14. 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

15. 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

16. Case Study (Continued) Example: T 4 1999/04/05 U.S T-note: Table shows: 1. Present values(5 th 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(6 th Column) of treasury strips each discounted with observed market yield to maturity Difference in present values leaves an opportunity for arbitrage

17. 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

18. 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.

19. Reconstitution (Continued) C-Strip P-Strip Coupon Bond

20. Case Study: Reconstitution Table shows: 1. Present values(5 th 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(6 th Column) of treasury strips each discounted with observed market yield to maturity Difference in present values leaves an opportunity for arbitrage

21. 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

22. 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

23. 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

24. 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 31 st 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

25. 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.

26. 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