Annex II Stripped Prices
- International Monetary Fund
- Published Date:
- January 1992
The existence of a discount on the secondary market for a bank claim on a sovereign borrower reflects the market’s perception of a risk that the claim will not be serviced. Accordingly, the secondary market price for a country’s bank debt provides a broad indicator of a country’s creditworthiness. The interpretation of secondary market prices is complicated, however, after a bank claim has been restructured and securitized. In particular, the secondary market price of a partially collateralized discount or par bond reflects not only the market’s assessment of the likelihood the borrower will service the claim, but also the incremental value that creditors expect to receive from the associated guarantee. Moreover, in the case of a reduced-interest par bond, the price reflects the degree of interest reduction compared with prevailing market rates. Hence, to construct a measure of the country’s perceived payment risk, it is necessary to “strip off” the contribution to the bond’s market value by the attachment of a payment guarantee, and to normalize the price for the degree of interest reduction.
The approach to “stripping” adopted here is based on the realization that a partially collateralized security can be characterized as a portfolio of two different payment streams: one that is guaranteed and carries no default risk, and another that is unguaranteed and subject to country risk. By subtracting the value of the guaranteed obligations from the secondary market price, one can derive the market value of the “risky” claims. The stripped price, a measure of a country’s perceived payment risk, is subsequently derived from the ratio of the market value of the risky claims to their hypothetical value in the absence of payment risk. As a result of this “normalization,” stripped prices are comparable across different types of instruments.
Turning to the actual calculations, the stripped price (ps) is defined as the ratio of the market value of the risky payment obligations (MVr) to the present value of these same obligations (PVr).2
The market value of the risky obligations is estimated by subtracting the current value of the collaterals MVc (the present discounted value of the future income stream that creditors expect to receive directly or indirectly from the collateral account) from the observed market value of the bond (MVb), that is,
Similarly, the present value of the risky obligations is estimated by calculating the present value of the total obligations on the bond less the present discounted value of the obligations covered by the principal guarantee:
Since the prepaid obligations are riskless, their present discounted value equals their market value. Hence,
Combining equations (1), (2), and (4) gives the result:
If the stripped price equals one, this implies that MVb = PVb, that is, the borrower could issue new debt with a maturity similar to the bond with a yield equal to the market discount rate.
Movements in market interest rates will be reflected in the price of the bond to the extent that they affect the value of the guarantees and the present value of the obligations. However, such movements will affect the stripped price only to the extent that they change the country’s perceived payment risk. For example, an increase in market interest rates will decrease the value of the principal guarantee which, other things being equal, should decrease the market value of the bond. Similarly, higher market interest rates should lower the present value of a fixed interest par bond, and thus decrease the hypothetical present value of the bond. The stripped price should not, however, be directly affected by changes in the value of the guarantee or the present value of the bond.
Stripped prices are more volatile than the quoted market price of the bond. Movements in stripped prices only affect the value of the risky component of the bond; the value of the payment guarantee remains unaffected. Thus, movements in stripped prices affect the value of the bond less than proportionally. The degree of correlation between the bond’s market price and the stripped price is inversely related to the share of the value of the bond covered by the payment guarantee.