STRIPS are created by stripping conventional bonds into which cash flows?

• A. Principal payments only
• B. Coupon payments and the bond repayment
• C. Tax payments
• D. Currency exchanges

Answer: (B)

STRIPS involve taking a standard bond and separating its schedule of payments into individual zero-coupon pieces. Each cash flow the bond would pay—every coupon when it’s due and the final repayment of the principal at maturity—is isolated and sold as its own instrument. Because these are zero-coupon, they don’t pay interest periodically; instead, they mature at a single future date to deliver that specific cash flow.

So the cash flows that are stripped out are the coupon payments and the bond’s repayment of principal. Tax payments or currency exchanges aren’t part of the bond’s cash-flow schedule, and focusing only on principal would miss the coupon payments.