Zero-Coupon Bond

Zero-Coupon Bond is also called as discount bond or strips and coupon bonds. A zero-coupon bond makes a single payment on its maturity date, while a coupon bond makes interest payments at regular dates up to and including its maturity date. A coupon bond may be regarded as a set of strips, with the payment on each coupon date and at maturity being equivalent to a zero-coupon bond maturing on that date. This equivalence is not purely academic. Before the advent of the formal market in U.S. Treasury strips, a number of investment banks traded the cash flows of Treasury securities as separate zero-coupon securities.   A zero-coupon bond is the simplest fixed income security. It makes no coupon payments during its lifetime. Instead, it is a discount instrument, issued at a price that is below the face or principal amount. The rate earned on a zero-coupon bond is also referred to as the spot interest rate.  

Valuation of zero-coupon bond

For zero-coupon bond, there is only one cash flow - the repayment of principal at maturity. The value of a zero-coupon bond that matures N years from now is

                                          Maturity Value
                                     (1+i) no. of years x 2

(Where i is the semiannual discount rate)

The calculation mentioned above explains that the rate of the zero-coupon bond is the current value of the maturity value.  In order to make sure the valuation of the zero-coupon bond constant with the valuation of the coupon bond. In other words, both zero-coupon and coupon bonds are valued with the help of semiannual compounding.

Questionnaire:

• What is zero-coupon bond?
• In the present value computation, why is the number of period is used for discounting rather than the number of years to the bond’s maturity where there are no semiannual coupon payments?