Financial innovation and the role of derivative securities: An empirical analysis of the treasury STRIPS program

The role that financial innovation plays in financial markets is very contr oversial. To provide insight into this role, we examine how market particip ants use the highly successful Treasury STRIPS program. We find that invest ors use the option to create Treasury-derivative STRIPS primarily to make m arkets more complete and take advantage of tax and accounting asymmetries. Although liquidity-related factors help explain differences in the prices o f Treasury bonds and STRIPS, we find little evidence that the option to str ip and reconstitute securities is used for speculative or arbitrage-related purposes.