Hi David,

Can you explain this fact with complete calculation?  I am just unable to follow to this complete AIM. If possible with a spreadsheet.
Besides I have one request if along with the screencast ,infact in the screencast you solve the previous yrs FRM question then It would be very handy.If not possible you can provide us with these questions in some other section.
Thnx
Sipani

Hi sipani,

I glossed over this in the screencast, admittedly. I just added to the member page > editgrid the relevant spreadsheet (see latest editgrid). This replicates from Tuckman’s chapter 2: maturity versus bond price and maturity versus bond return (see green row 35 starts the ‘versus bond return’)

The building block idea here, which IMO is worth mulling over, is the bolded sentence: “It is no coincidence that when the six-month rate evolves according to the initial forward rate curve investors rolling short-term bonds and investors buying long-term bonds perform equally well. Recall that an investment in a bond is equivalent to a series of forward loans at rates given by the forward rate curve.” It occurs to me this last part shows up in a few places; e.g., when Hull values interest rate swaps as series of FRAs. So, it is worth contemplating this sentence.

A key theme in Tuckman is that the spot rate curve contains a series of forward rates. He did not need a coupon bond for the example here. Say we both invest for 5 years and the yield curve is flat at 5%. In such an unrealistic yield curve, not only are all the spot rates 5%, but here is the idea: the implied forward rates are also 5%.

I can then buy a zero coupon bond for $77.88 (=$100 * EXP(-5*5%))

You, because you think short rates will rise during the five years, do not want to lock in for so long, and you instead invest in a 12 month CD and roll it over for one more year, then another and another etc. If the yield curve doesn’t move in the meantime, we will earn the same. Me, because $100 buys $100/.7788 = 128 face value. You because $100 *EXP(25%) grows to 128.

The key to your earning the same as me is that you do in fact roll over into 5% rates. Specifically, “the [one year rate] evolves according to the initial forward rate curve.” His whole point here is that (i) the spot curve contains a set of forwards, and (ii) that if you invest short and roll over you are implicitly betting the forward rate underestimates the future *realized* spot rate.

I hope that helps, I don’t think i quite understand your second part, the request?

David

Hi David,

Thnx for this wonderful explanation. That was helpful.
I missed to ask one more point.
“In regard to P-STRIPS Tended to trade fair Or rich “because the associated bonds trade rich””....can you explain these two points ? Why should it be fair because P-Strips should follow the characteristic of Long term C Strip (If I am not getting it wrong!!!!!!!).
Your spreadsheets are really awesome.
The request was to include those questions that have appeared earlier in the previous years FRM examination so that we get a feel what type of questions are actually asked in the paper.

Thnx
Sipani

Hi sipani,

Tuckman says the C-STRIPS are “fungible” and the P-STRIPS are not. This thread may help:
http://www.bionicturtle.com/forum/viewreply/486/ stripped coupons on same date are given the same CUSIP #, to they are interchangeable but the principal STRIP is linked to only its original bond.

Regarding the “trade rich/trade cheap,” I don’t know if Tuckmans 2001 data is still accurate. We might distinguish between fundamentals (i.e., prices implied by the pricing framework) and technicals (e.g., supply/demand, liquidity). Fundamentally, per “law of one price” (is an AIM), your suggestion is true (according to Tuckman): the spot rate (and therefore the price) for a C-STRIP should be the same for a P-STRIP with the same maturity (that’s the law of one price: cash flow with same timing and risk, price/rate should be the same). But that’s “merely” the fundamental (pricing framework). Fundamental is the framework - technicals are the temporal reality.

Tuckman implies variations on fair price (rich/poor) for the strips are due to illiquidity and/or supply/demand. That’s technical factors and those can vary, etc. (or: illiquidity discount is a technical factor until you get it into the model, then it’s a modeled fundamental factor). So, that’s why i don’t get too concerned about his temporal findings here. “trade cheap” here means: less than price frameworks says because STRIP is illiquid and/or not very demanded; trade rich means greater than price framework b/c STRIP is liquid and more in demand.

Really glad you like the sheets! Previous questions: not sure i follow, have you seen the sample exams on the member page and the quizzes in the middle column, as they are not 2008 yet, are last years...David

Thanks, David

Hi David,

I am neither requesting you the questions from sample paper nor some new quizzes from your side.All the questions that have appeared in previous “actual” FRM examination. Say questions from FRM 2007 ,FRM 2002, etc...I hope now I am clear.

Thnks,Sipani

Sipani,

Oh, yes, I have asked for these many times. But GARP has, to my knowledge, never released actuals - my GARP contact has hinted we *might* see the 2007 but I am not counting on it yet. I’ll keep you updated. I very much would like to see them too...David

Hi David,
Never knew that they dont release the actual questions. Any way thanks.By the way is it possible for you to put those flash questions in pdf form?
Sipani

(maybe they are concerned about implications vis a vis non passers?)

re: PDF, as we speak, I have a flash/flex guru converting the flex quiz to (i) improve the “print to” feature (I will ask him to include PDF, that is not problem for flex) and (ii) to make the flash quiz downloadable...i don’t have timing yet...David