Zero-coupon bonds package

The yield analysis described above considers coupon bonds as packages of zeros. How does one compare the yields of zero-coupon and coupon bonds A two-year zero is clearly the point of comparison for a coupon bond whose duration is two years. What about very long-dated zero-coupon bonds, though, for which no equivalent coupon Treasury is usually available The solution lies in the technique of stripping coupon Treasuries, which allows implied zero-coupon rates to be calculated, which can be compared with actual strip-market yields. 

Because it is affected by current demand, the yield of a particular zero-coupon bond at any time may differ from the equivalent-maturity spot yield. When investors value an individual zero-coupon bond less highly as a stripped security than as part of a coupon bond s theoretical package of zero-coupon cash flows, the strip s yield will be above the spot rate for the same maturity. The opposite happens when investors prefer to hold the zero-coupon security. 

As shown in Eigures 1.4 and 1.5, with this swap structuring, the asset-swap spread for HERIM is 39.5 bp and for TKAAV is 39.1 bp. These represent the spreads that will be received if each bond is purchased as an asset-swap package. In other words, the ASW spread provides a measure of the difference between the market price of the bond and the value of the cash flows evaluated using zero-coupon rates. 

The simplest approach assumes, somewhat unrealistically, that the yield curve is flat and moves only in parallel shifts, up or down. It considers a bond to be a package of zero-coupon securities whose values are discounted and added together to give its theoretical price. The advantage of this approach is that each cash flow is discounted at the interest rate for the relevant term, rather than at a single internal rate of return, as in the conventional approach. Given the flat yield curve, however, this approach reduces to (17.3). An example of its application follows. 

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