Final answer:
You could profit by buying a Treasury bond and creating STRIPS if the value of the bond is lower than the sum of its parts. Present discounted value calculations take into account potential capital gains and dividends, and illustrate how investor opinions vary on future payments. An example highlighted the interest rate risk associated with bond investments.
Step-by-step explanation:
If the value of a Treasury bond was lower than the value of the sum of its parts (STRIPPED cash flows), one could profit by buying the bond and creating STRIPS. This arbitrage opportunity exists because the combined present discounted value of the separately traded STRIPS would be higher than the purchase price of the entire bond.
When considering the present discounted value to a bond, one needs to account for the potential capital gains from the future sale and also any dividends that might be paid. The selection of the correct interest rate for discounting is crucial as this affects the present value calculation. Investors' varying opinions about future payments and interest rates are what drive the differences in the buying and selling of financial instruments like stocks and bonds.
An example of interest rate risk: purchasing a 10-year bond at an 8% interest rate just before market rates rise to 12% would mean losing out on higher payment opportunities. The present discounted value can also be calculated, showing what investors will pay in present terms for future benefits expected from a bond.