Question

What is the price of a bond issued on 1/1/18 with a coupon rate of 6 %, having a 10-year maturity, paying interest twice a year, having a yield to maturity rate of 8%? Calculate the interest expense and cash payments per period, and the carrying value of the bond in year 5.

What is a zero coupon bond and what risks are inherent to the bond issuer with this type of bond? What should adjustment from a financial analysis point be made to overcome this risk?

Answer 1

Price of Bond is calculated with Following Formula ;

Price of Bond = C * [ 1- { 1 / (1+i)ⁿ } ] / i +      M / (1+i)ⁿ

^{Assumed Face Value is $ 1000}

^{Coupon = 1000 * 6 /100 *1/2 =60/2 = $30}

^{Bond Price =  30 *   [ 1- { 1/ (1+0.04)^20} ]   / 0.04   + 1000 / (1+ 0.4) ^20}

=   30 * [ 1 - 0.45638] /0.04 +     100 / 2.19115

= 30 * 13.5905 + 456.38

Value of Bond = $ 864.09

Interest expense and cash payments per period = 1000* 6% * ½

= $ 30 per Half Year

In the Fifth Year Carrying Amount of Bond =

End of Year	Interest	Principal	Present Value
0.50	$30.00		$28.85
1.00	$30.00		$27.74
1.50	$30.00		$26.67
2.00	$30.00		$25.64
2.50	$30.00		$24.66
3.00	$30.00		$23.71
3.50	$30.00		$22.80
4.00	$30.00		$21.92
4.50	$30.00		$21.08
5.00	$30.00		$20.27
5.00		$1,000.00	$675.56
		TOTAL	$918.89

Zero Coupan Bound = zero-coupon bond is a Bond that doesn't pay interest (a coupon) but is traded at a deep discount, rendering profit at maturity when the bond is redeemed for its full face value. And Margin Between Issue price and Price Received at Maturity is return of Investor on his investment.

Risk associated with ZCB

1. Taxes

One of the big disadvantages of this type of bond fund is that you are going to have to pay taxes on the interest that is accumulating in the fund. This means that you will have to come up with money from some other source because you are not actually going to be receiving the interest payments until a date in the future.

How to Avoid this Risk : Make Proper Tax Planning and opt for those investment provide Tax Rabate or Benefit .

2. Volatility

Another potential problem with this type of bond fund is that share prices can be very volatile. The prices of this type of fund can fluctuate greatly depending on changes in the interest rates in the market. If interest rates in the market increase, the prices of your shares can depreciate rapidly.

How to Avoid this Risk : Proper analysis of financial market , Government Policy , Fiscal Policy , stock market condition is required before making investment in ZCB

3. Selling before Maturity

In some cases, investors have to sell their shares before the bonds mature. When you do this, you are potentially going to be sacrificing a good portion of the potential returns for the bonds. This is more suitable for those that can stay in the fund until maturity.

How to Avoid this Risk : Investor should avoid selling bonds before maturity and this Investor should invest only those fund in ZCB which has no recent use and will remain invested for longer period of time let say 10 years 20 years etc.