# US Treasury STRIPS: Pricing and Risks

The prices of STRIPS are quoted on a discount basis, as a percentage of par. Eligible securities can be stripped at any time. For a book-entry security to be separated into its component parts, the par value must be an amount which, based on the stated interest rate, will produce a semiannual interest payment of $1,000 or a multiple of $1,000. Quotes for STRIPS are quoted in yields to maturity.

**Hedging**

Zeros are typically hedged in the futures or options markets, or by taking a contra position in another Treasury security. The effectiveness of any hedge depends on yield-curve and basis risk. Also, if a position in zeros is hedged with an OTC option, the relative illiquidity of the derivative Treasury security and the option may diminish the effectiveness of the hedge.

**Risks**

The two key risks are interest rate risk and liquidity risk. There is no credit risk because STRIPS are considered to be free from default.

**Interest-Rate Risk**

Increases in the level of interest rates increase the advantages of stripping. This is because the constant-yield method applied to premium bonds results in a lower price than linear amortization does. Zeros have higher sensitivity to changes in interest rates than bonds with the same maturity. Because they are zero-coupon bonds, their duration equals their maturity. The higher the duration, the higher the potential volatility.

**Liquidity Risk**

The STRIPS market is significantly less liquid than the U.S. Treasury bond market. Investors encounter wider bid/ask spreads and are subject to higher commissions. In addition, liquidity may fluctuate significantly in times of market instability. However, since a dealer can strip or reconstitute bonds in a fairly flexible manner, if zero-coupon prices diverge too far from their equilibrium levels, a new supply can be created or reduced through the stripping and reconstitution process.

*Reference: Federal Reserve Board*

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