A zero-coupon bond is a debt security that does not pay interest but instead trades at a deep discount, rendering a profit at maturity, when the bond is redeemed for its full face value. A zero-coupon bond is also known as an accrual bond.
Some bonds are issued as zero-coupon instruments from the start, while others bonds transform into zero-coupon instruments after a financial institution strips them of their coupons, and repackages them as zero-coupon bonds.
Formula of Zero Coupon bond: Price= F / (1 + r)n
F= face value of the bond, R= rate of interest, N= number of years until maturity
Example- A person is looking to purchase a zero-coupon bond with a face value of Rs 1,000 and 5 years to maturity. The interest rate on the bond is 5% compounded annually. What price will that person pay for the bond today?
Price of bond = Rs 1,000 / (1+0.05)5 = Rs 783.53
The price that person will pay for the bond today is Rs 783.53.
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