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Lecture_2_Questions-First_Set - Lecture 2 Questions-First...

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Lecture 2 Questions-First Set 1. What’s coupon stripping? How can it create arbitrage opportunities? Answer: Coupon stripping entails taking a conventional bond and selling each of the cash payments as a separate security. To have an arbitrage opportunity with coupon stripping, one needs to be able to sell the pieces for more than the whole. To have an arbitrage opportunity with reconstituting (which is the reverse of stripping), one needs to be able to sell the bond for more than the strips. In other words, buying strips and selling bonds should leave you with profit. 2. Can arbitrage opportunities such as coupon stripping, etc. be exploited as easily? What other considerations should be taken into account when we think about these arbitrage opportunities? Answer: There’s not necessarily an arbitrage opportunity from either stripping or reconstituting. This might be due to transaction costs (in the form of dealers’ bid-ask spreads) that doesn’t allow the exploitation of small price differentials (between strip and bond prices) in either direction. A trader should also be careful about transaction costs other than the dealers’ bid-ask spreads. In addition, one should be careful about using prices that are only newspaper quotations rather than actual contemporaneous dealer quotes, since the dealers are not committed to trade at these prices.
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