Financial Innovation in an Incomplete Market: An Empirical Study of Stripped Government Bonds

Hiromitsu Kanemasu, Robert H. Litzenberger and Jacques Rolfo

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: The unbundling of' coupon bonds into pure discount bonds made feasible patterns of dated nominal claims that were not previously attainable. Differences between the market values of coupon bonds and the spanning portfolios of pure discount bonds are consistent with a non-tax related segmentation of the bond market. In most periods, long-maturity coupon bonds selling at a premium could have been profitably unbundled. A comparison of pure discount bond prices with estimates of the respective reservation prices for investors in coupon bonds indicates that long-term time-contingent claims were generally more highly valued once unbundled. The high initial profit from bond stripping and its subsequent decline are consistent with long-run competitive supply adjustments by investment banks. Volatility differences of actual and reservation prices for pure discount bonds are insignificant.

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