Is Risk Arbitrage Compensated? Evidence from the European STRIPS Market

Abstract

Previous published studies document price differences between principal and coupon strips although both securities promise identical cash flows at maturity. This paper gauges the economic significance of this apparent anomaly and investigates if holders of the higher-priced strips can exploit the observed price differences by switching to lower-priced strips. Our empirical analysis of the main European strips markets finds that potential switching profits are economically very small. Switching operations by investors keep prices of principal and coupon strips very close to one another. Investors are only marginally compensated for the risks of risk arbitrage in the European strips market.

Keywords: Arbitrage, Bonds, Risk Arbitrage, Strips

JEL Classification: G11, G12, G14