Zero-coupon bond

Definition

A zero-coupon bond is a debt security that does not pay periodic interest payments, or 'coupons', but is instead issued at a discount to its face value. The investor receives the face value upon maturity, with the difference between the purchase price and the face value representing the return on investment. This concept connects to spot rates, as the pricing of zero-coupon bonds relies on the present value of future cash flows derived from these rates. Additionally, understanding how these bonds are priced is essential for calculating duration and convexity, as they exhibit unique sensitivity to interest rate changes. Bootstrapping techniques often use zero-coupon bonds to derive the yield curve, providing a foundation for valuing more complex financial instruments.

5 Must Know Facts For Your Next Test

1. Zero-coupon bonds are sold at a price significantly lower than their face value, allowing investors to benefit from the difference upon maturity.
2. Because they do not make periodic interest payments, zero-coupon bonds are more sensitive to changes in interest rates compared to coupon-bearing bonds.
3. The duration of a zero-coupon bond is equal to its time to maturity since it has only one cash flow at that point in time.
4. Investors in zero-coupon bonds must be aware of tax implications, as imputed interest income may be taxable even though no cash is received until maturity.
5. Bootstrapping often involves using zero-coupon bonds to create a zero-coupon yield curve, which is fundamental for pricing other securities.

Review Questions

• How does the lack of periodic interest payments affect the pricing and risk profile of a zero-coupon bond?
  • The absence of periodic interest payments means that all returns come from the difference between the purchase price and face value at maturity. This structure leads to greater price sensitivity to interest rate fluctuations, making zero-coupon bonds riskier in terms of market volatility. Investors need to consider this risk when determining their portfolio strategy and asset allocation.
• In what ways do spot rates influence the valuation of zero-coupon bonds, and why are they important for investors?
  • Spot rates play a crucial role in valuing zero-coupon bonds by providing the necessary discount rate for calculating present values. Each cash flow from a zero-coupon bond can be discounted at its respective spot rate based on the time until maturity. For investors, understanding spot rates allows them to accurately price these bonds and assess their investment returns relative to market conditions.
• Evaluate how bootstrapping techniques utilize zero-coupon bonds in constructing the yield curve and their implications for financial markets.
  • Bootstrapping techniques leverage the pricing of zero-coupon bonds to derive a comprehensive yield curve, which reflects current market interest rates across different maturities. This process involves calculating spot rates from observed prices of zero-coupon bonds and allows for better pricing of other financial instruments. The resulting yield curve provides critical insights for investors and analysts regarding expected future interest rates and helps in making informed decisions about investments, hedging strategies, and economic forecasting.

Related terms

Discount Rate: The interest rate used to determine the present value of future cash flows, critical in pricing zero-coupon bonds.

Face Value: The amount paid back to the bondholder at maturity, which is higher than the initial purchase price for zero-coupon bonds.

Yield Curve:

A graph that shows the relationship between bond yields and maturities, often constructed using zero-coupon bonds.