“Securities are created by dividing the cash flows associated with underlying securities into two or more new securities”. Explain the instruments…

Stripped Securities are created by dividing the cash flows associated with underlying securities into two or more new securities. Those two securities are as follows: (i) Interest Only (IO) Securities (ii) Principle Only (PO) Securities As each investor receives a combination of principal and interest, it can be stripped into two portion of Interest and Principle. Accordingly, the holder of IO securities receives only interest while PO security holder receives only principal. Being highly volatile in nature these securities are less preferred by investors. In case yield to maturity in market rises, PO price tends to fall as borrower prefers to postpone the payment on cheaper loans. Whereas if interest rate in market falls, the borrower tends to repay the loans as they prefer to borrow fresh at lower rate of interest. In contrast, value of IO's securities increases when interest rate goes up in the market as more interest is calculated on borrowings. However, when interest rate due to prepayments of principals, IO's tends to fall. Thus, from the above, it is clear that it is mainly perception of investors that determines the prices of IOs and POs