Zero Coupon Bonds Case

COUGARs

Zachary Schuit

* Zero-Coupon bonds have been very successful and popular among investors, because they can be bought at a large discount from their face value. Furthermore, the investor knows the exact amount they will receive in a lump sum at the bond's maturity date. Zero Coupon bonds don't pay any interest throughout the life of the bond. At maturity the bondholder will receive an amount equal to the initial investment along with the implied interest. These type of bonds have long term maturities so investors can diversify their portfolio and use for long term type goals. Bottom line, these bond types are successful due to them being sold at a large discount, it is riskless because it is because the investors know exact money they will get when it gets mature. For this reason, it is important in the fixed income security market. And in effect investor can spend a small amount of money that can grow over many years.

* Zero Coupon Bonds with long term interest rates are higher than zero coupon bonds short-term interest rates. This shown through the higher inflation-risk premium demanded by investors for bonds that have a longer term to maturity. 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 particular coupon date. Bond duration measures sensitivity of bond's price to changes in interest rate

* Treasury STRIPS change each principal payment and coupon payment into a separate individual zero-coupon security. The Treasury yield curve is take from the Treasury strips prices. In other words STRIPS are zero-coupon bonds that are traded for various maturities. From the strip prices, you can find the yield curve. The spot rates are used to discount the future cash flows of bonds. Any coupon bond can be engineered from a portfolio of zero-coupon bonds. Spot rate is the yield on a zero-coupon bond. The yield curve that contains spot rates is defined as the spot rate curve.

* From the information provided in the case, we technically have three yield curves:

* Implied Spot Yield curve from May 1984 to November 1993 has a trend moving upward and then remaining flat.

* Cougars Strip Yield Curve has a discount rate of 8.11% that need to be taken into consideration. You need to make an adjustment, because the prices shown in Exhibit 1 December 16 1983 why the treasure quotes are 20 days earlier on November 16 1983. It has a discount factor of 1.0045 (calculation: 1+0.0811*20/360). The yield curve has upward trend before November 1987, and then it remains flat afterwards

* Treasury Coupon Yield curve: This yield curves also shows an upward trend before November 1987, and then stays flat as a whole.

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