STRIPS: Bond and Options Terminology
Definition
STRIPS (Separate Trading of Registered Interest and Principal of Securities): STRIPS are a type of zero-coupon bond introduced by brokerage houses that separate the bond into its interest (coupon) and principal (corpus) components. Each component is then sold individually. Specifically for the U.S. Treasury, STRIPS allows individual investors to purchase zero-coupon securities that reflect separated interest and principal payments.
Detailed Explanation
Bonds: For bonds, STRIPS involve the practice of separating a bond into its interest (coupons) and its principal (corpus). These separated components are then sold independently as zero-coupon securities. Unlike traditional bonds, where interest is periodically paid to the holder, holders of STRIPS receive a lump sum at maturity. This is particularly beneficial for investors seeking predictable returns or aiming to match assets with future liabilities.
Options: In the realm of options, STRIPS represent an option contract comprising two put options and one call option on the same underlying asset with identical strike prices and expiration dates. This type of option strategy allows investors to capitalize on significant declines in the underlying asset’s price.
Examples
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Bond STRIPS: An investor purchases a 10-year U.S. Treasury bond. The brokerage house then strips the bond into 20 separate zero-coupon bonds — representing semiannual interest payments — and one zero-coupon bond reflecting the principal. Each of these 21 components can be traded independently.
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Options STRIPS: An investor uses the STRIPS strategy by holding two put options and one call option on stock XYZ with a strike price of $100, maturing on the same date. This strategy is beneficial if the investor anticipates a decline in the stock’s price.
Frequently Asked Questions (FAQs)
Q1: How do STRIPS differ from regular bonds? A1: Unlike regular bonds that pay periodic interest, STRIPS do not pay interest periodically. Instead, they provide one lump-sum payment at maturity, making them zero-coupon securities.
Q2: Who typically invests in STRIPS? A2: STRIPS are often favored by investors looking for predictable, fixed-income investments, such as retirees, as well as institutions matching assets to future liabilities, like pension funds.
Q3: What are the tax implications of STRIPS? A3: Investors must pay federal income tax on the imputed interest of STRIPS annually, even though they do not receive this interest until maturity. However, they are exempt from state and local taxes.
Q4: Can STRIPS be bought directly from the U.S. Treasury? A4: No, STRIPS must be purchased through a financial institution or brokerage, not directly from the Treasury.
Q5: Are there any risks associated with STRIPS? A5: Like all bonds, STRIPS are subject to interest rate risk. Their prices can be highly sensitive to changes in interest rates.
Related Terms
- Zero-Coupon Bond: A bond that does not pay periodic interest. Instead, it is sold at a discount and redeemed at face value at maturity.
- Principal (Corpus): The original amount of the bond that is to be repaid at maturity.
- Coupon: The periodic interest payment made to the bondholder.
- Call Option: An option contract giving the holder the right to buy a specified asset at a specified price within a specified period.
- Put Option: An option contract giving the holder the right to sell a specified asset at a specified price within a specified period.
Online References
Suggested Books
- “Fixed Income Securities: Tools for Today’s Markets” by Bruce Tuckman and Angel Serrat
- “The Handbook of Fixed Income Securities” by Frank J. Fabozzi
- “Options, Futures, and Other Derivatives” by John C. Hull
- “Bond Markets, Analysis, and Strategies” by Frank Fabozzi
Fundamentals of STRIPS: Bonds and Options Quiz
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