Wednesday, October 28, 2009

Spot Rates and Bonds - Supply and Demand of Investment Vehicles

We were discussing Treasury strips for CI (Coupon Interest) and NP (Note Principle) bonds. We discussed ideas such as reconstituting bonds, arbitrage opportunities and pricing.

I had wondered before if when investment vehicles get "abstracted" (either with a derivative, in some form of aggregation etc), if it was possible to get supply and demand curves which differ from the original underlying asset.

Prof. Womack showed us the example of two otherwise identical treasury strips, both maturing in 2 years with the same $100 Face Value, but trading at nearly the same (but marginally different) prices. One was a CI strip with the ask yield at 5.78% with an ask price at $89/08 and the other was an NP strip with an ask yield at 5.79% with an ask price of $89/07.

Although these two investment vehicles have identical risk profiles, payment schedules etc. (for all intents and purposes, they are identical) they are trading at different prices. Prof. Womack described the different as being differences in supply and demand for investors who are interested in reconstituting bonds (for example). However, at the same time, since they are so related, they should trade at near identical values.

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