Case Study - Cougars

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Date Submitted: 11/28/2012 01:49 PM

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In the early eighties, COUGARs were still relatively new to the markets. These zero coupons bonds gradually became an attractive opportunity for investors. For those who had been in the industry for awhile, such as Josephine Baker, these new types of bonds required some research to determine why they were so attractive.

Riskless zero coupon bonds have been very successful with investors. For one, they generally can be purchased at a deep discount. As shown in Exhibit 1 of the case, a twenty year zero coupon bond could have been purchased in 1983 at only 10.455% of its face value. The investor who purchases this bond would collect a lump sum (the bond’s par value) at its maturity. For example, a bond with a $100 par value would have only cost $10.46 in 1983, but when it matures in 2003, the investor would collect $100. These are attractive because of the low initial investment, and because he or she can use them to plan for long term goals, such as college tuition.

Although zero coupon bonds do not pay a coupon to investors, they are priced to reflect interest rate risk. As an investment security is held longer, generally the interest paid on that security increases. This is because of the risk for inflation. Similarly, with zero coupon bonds, the longer the bond is held, the lower the purchase price is. Since these bonds do not earn a coupon, their interest is the difference between the par value and the initial price. As the initial price of the bond decreases, the amount the investor earns of his or her investment increases.

There is a relation between the spot, strip and the coupon yield of a bond. Treasury STRIPS are fixed income securities which convert coupon and principal payments into zero coupon investments. They are sold at a discount to par, and pay no coupons to the investor. At maturity, the face value of the bond is paid to the investor. The treasury yield curve derives from the pricing of the STRIPS. The spot rates on...