Question

The government in the U.S. issues zero-coupon bonds up to one-year maturity, but STRIPS are "manufactured" zero-coupon bonds with maturities up to 30 years. So, for example, a financial institution could first buy 250 30-year coupon bonds issued by the government that each pays $4 of coupon every six months. The institution could then sell the combined coupons totaling $1,000 as a separate zero-coupon bond for each maturity ranging from 6 months up to 30 years. This is a financial innovation that occurred decades ago in the face of volatile inflation and increased demand for long-term zero-coupon government bonds. Given this information, analyze the following statement: "The price of a long-term STRIP will typically be lower than that of a short-term STRIP."

Answer 1

"The price of a long-term STRIP will typically be lower than that of a short-term STRIP."

There are two reasons behind this:

1. Interest rates will be higher in case of long term bonds:

With a longer duration, the probability of changes in interest rates will be more. And, long term bonds have more risk. Thus the interest rates will be higher.

2. As the zero coupon bonds have no coupon payments, price will be indicative of the unpaid coupons.

Because of the above two reasons, it is logical that longer duration bonds(Long term STRIPS) will have lower price.