Risk Arbitrage, Switching, and the Relative Pricing of Coupon and Principal Strips
Speaker
Abstract
| An observed anomaly in the strips market is the tendency for principal strips to sell at higher prices than coupon strips although both securities promise identical cash flows at maturity. This paper develops a theoretical framework showing that, even though risk arbitrage does not put limits on price differences, switching by investors between principal and coupon strips keeps the differences smaller than twice the bid-asked spread of the lower-priced strip. Actual price differences are found to be inside the boundaries implied by our switching argument for most cases. Price differences increase with maturity. The higher prices for principal strips and the tendency for price premiums for principal strips to increase with maturity can be explained by coupon strips trading as a package. The package of coupon strips has less liquidity and lower prices for individual coupon strips compared to principal strips with the same maturity. The liquidity of coupon strips is reduced for longer maturities because of a larger number of coupon strips in a package. |
| The Erasmus Finance Seminar is jointly sponsored by ERIM and the Tinbergen Institute. |
| Contact information: |
| Viorel Roscovan |
