Stripping Coupons with Linear Programming

Abstract

When using market prices to fit the parameters of models for the price of bonds, the first step is to strip the market bonds of their coupons. The standard bootstrapping technique of stripping coupons can cause mispricing if there are no bonds that mature for some periods or if there are several bonds that mature at the same time. The authors suggest a new linear programming formulation to strip out riskfree and risky zero coupon bond prices, which works whatever the current date, coupon dates and sampling dates. The stripped US Treasury bond prices match the observed US STRIPS prices. The issues of liquidity, sampling periods and implied default probabilities of corporate bonds are also discussed.