A zero coupon bond is a bond that does not pay dividends or coupons per period but instead is sold at a discount from the face value.
Importance of Zero Coupon Bond
A zero coupon pays one lump sum on maturity bond and not dividend payments. Face value is the amount paid at maturity. The term ‘discount bond’ shows that how it is sold originally. At a discount from its face value instead of the standard pricing; inclusive of the periodic dividend payments.
Zero coupon bond value = (Face Value / Current Price of Bond) ^ (1 / Years to Maturity) - 1
Let’s consider $1,000 zero coupon bond that has 2 years until maturity. The bond is currently valued at $925 (the price it could be purchased at today). The formula would look like: (1000 / 925) ^ (1 / 2) - 1. When solved according to the above formula, this equation produces a value of 0.03975, or 3.98%.