Zero-coupon bonds have been successful because they can be purchased by investors at a deep discount from their face value and because the investor knows exactly how much they will collect in a lump sum at the bond’s maturity date. Zeros do not pay interest during the life of the bond and at maturity; the investor receives an amount equal to the initial investment plus the imputed interest. Zeros are offered for long-term maturities, so that investors can use them to plan for long-term goals and to diversify their portfolio. Ultimately, zero-coupon bonds are successful because they are sold at a deep discount, so an investor can spend a small amount of money that can grow over many years.
2. What relationship do the prices of riskless zero-coupon bonds have with the term structure of interest rates?
Longer-term interest rates are higher than shorter-term interest rates. This reflects the higher inflation-risk premium that investors demand for longer-term bonds. The term structure of interest rates is graphed as though each coupon payment of a riskless bond were a zero-coupon bond that matures on the coupon date.
3. How are spot, strip and coupon yield related?
Treasury STRIPS convert each coupon and principal payment into a separate zero-coupon security. The Treasury yield curve is obtained from the prices of Treasury strips. Strips are essentially zero-coupon bonds which are traded for a variety of maturities. From the strip prices, you can directly obtain the yield curve. The spot rates are what are used to discount the future cash flows of bonds. Any coupon bond can be engineered from a portfolio of zero-coupon bonds. The yield on a zero-coupon bond is called a spot rate; the yield curve that consists of spot rates is called the spot rate curve.
4. From the data in the case, reproduce implied spot curve. Compare it against Cougar Strip curve. 5. Discuss...