Question #19
Reading: Reading 26 The Arbitrage-Free Valuation Framework
PDF File: Reading 26 The Arbitrage-Free Valuation Framework.pdf
Page: 9
Status: Incorrect
Correct Answer: A
Your Answer: B
Question
The process of stripping is most likely to be used to earn arbitrage profits in a situation where:
Answer Choices:
A. a portfolio of treasury strips is trading for a lower price than an intact treasury bond
B. one treasury bond trades at a lower price than another treasury bond with identical characteristics
C. Security valuations are not consistent with the value additivity principle
Explanation
If the principle of value additivity holds, it will not be possible to earn arbitrage profits
through stripping (or reconstitution). If a portfolio of strips is trading for less than the
price of an intact bond, one can purchase the strips, combine them ("reconstitution"), and
sell them as a bond. Similarly, if the bond is worth less than its component parts, one
could purchase the bond, break it into a portfolio of strips ("stripping"), and sell those
components. When one security trades at a lower price than another security with
identical characteristics, this is known as dominance, and the arbitrage required to earn a
profit involves going long the underpriced security and short the overpriced security.
(Module 26.1, LOS 26.a)
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