Zero Coupon Bond
A zero-coupon bond (accrual bond) is a type of financial security that doesn't pay interest regularly but trades at a significant discount. The bondholder makes a profit when the bond matures and is redeemed for its full face value.
How do zero-coupon bonds work?
Zero-coupon bonds are sold at a discount because they don't issue periodic interest payments (coupons). To understand this, consider the time value of money, which states that money today is worth more than the same amount in the future. For example, receiving $100 today is preferable to receiving $100 in a year because you could invest it now and earn interest over the year.
Applying this to zero-coupon bonds, buyers today must be compensated with a higher future value. Since the issuer needs to provide a return for the investor, zero-coupon bonds are sold at a lower price than their face value.
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Pricing zero-coupon bonds
The price of a zero-coupon bond can be calculated using the formula:
Price = m/(1=r)n
Where:
- M is the maturity value or face value of the bond
- r is the required rate of interest
- n is the number of years until maturity
What makes zero-coupon bonds unique?
The key difference between zero-coupon bonds and regular bonds is the payment of interest. Regular bonds, also known as coupon bonds, pay periodic interest throughout their life and repay the principal at maturity. Zero-coupon bonds, on the other hand, don't pay interest but instead are sold at a discount, allowing the investor to earn a profit when they redeem the bond at its full face value at maturity.
Example of a zero-coupon bond
Let's say Emma wants to invest in a zero-coupon bond to save for her daughter's college education. She finds a bond with a face value of $10,000 that matures in 10 years and has an annual interest rate of 4%.
Using the formula:
Price = 10,000/(1+0.04)^10 = 10,000/1.48024 = 6756.76
Emma will pay $6,756.76 today for the bond. When the bond matures in 10 years, she will receive $10,000, which she can then use for her daughter's college expenses. The difference of $3,243.24 represents the interest earned over the 10-year period.
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Conclusion
Zero-coupon bonds don't pay regular interest. They are sold at a significant discount and mature at their full face value.
The returns on a zero-coupon bond is the difference between the purchase price & the face value.
Fun fact: Zero-coupon bonds are sometimes used by parents to save for their children's future education costs, as they can be purchased at a deep discount and mature when the funds are needed for college.
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