Effective six-month return YTM/2 assuming we can reinvest all coupons at the coupon rate 8, effective Annual. Short-term zero coupon bonds generally have maturities of less than one year and are called bills. Each of these investments then pays a single lump sum. For example, if the face value of a bond is 1,000 and its coupon rate is 2, the interest income equals. These packages may consist of a combination of interest (coupon) and/or principal strips.
In the United States, a zero-coupon bond would have Original issue discount (OID) for tax purposes. 1, note that this definition assumes a positive time value of money. The decision on whether or not to invest in a specific bond depends on the rate of return an investor can generate from other securities in the market.
It does not make periodic interest payments, or have so-called coupons, hence the term zero-coupon bond. Physically created strip bonds (where the coupons are physically clipped and then traded separately) were created in the early days of stripping in Canada and the.S., but have virtually disappeared due to the high costs and risks associated with them. More simply, a zero-coupon bond has the important advantage of being free of reinvestment risk, though the downside is that there is no opportunity to enjoy the effects of a rise in market interest rates. The problem is you get paid based on the prevailing rates, so lets say the rates go up quite a bit while you hold the bond but when it finally matures the rates are lower than when you initially purchased, then you have a problem. Suppose the bank holds 3 assets Duration of total assets: 6, example Bank Assets: Asset 1: PV 8MD*12.5 Asset 2: PV38MD*18.0 Asset 3: PV 2MD*.75 Total PV 48M v 1 8/480.17, v 2 38/480.79v 3 2/480.04 Modified Duration of Portfolio:.17.5) (0.79. Possible to incorporate convexity into analysis above. Instead of paying interest, the issuer sells the bond at a price less than the face value at any time before the maturity date. (Which may not be face.) What happens is that as interest rates rise and fall, the price that a bond will buy or sell for adjusts so that the YTM matches the current YTM of new similar bonds. The coupon rate represents the actual amount of interest earned by the bondholder annually while the yield to maturity is the estimated total rate of return of a bond, assuming that it is held until maturity.
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