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Why is a zero coupon bond more sensitive to interest rates than just a coupon bond? Forum's RSS Feed Share

RGTrader's picture
(Monkey, 63
 
Points)
 on 2/4/12 at 2:12am

It doesnt really make sense to me, any ideas? thanks!

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swagon's picture

The cash you receive - just

EN
(Neanderthal, 2,934
 
Points)
  on 2/4/12 at 2:31am

The cash you receive - just one big payment when the bond matures - is far out in time, so the present value of that cash flow is more sensitive to changes in the discount rate than a regular bond, whose interest payments come before maturity i.e. earlier in time which is why those cash flows are less sensitive to changes in the discount rate.

RGTrader's picture

Got it! Thanks!!!!

(Monkey, 63
 
Points)
  on 2/4/12 at 2:40am

Got it! Thanks!!!!

oktopuss's picture

Indeed, key word is duration

(Chimp, 9
 
Points)
  on 2/4/12 at 3:50am

Indeed, key word is duration (look it up if you're not familiar); a zero coupon bond will always have duration equal to maturity, which makes it more sensitive to interest rate changes. A coupon paying bond will have a duration lower than it's years to maturity because you receive cash flow in the meantime

timothy0's picture

Yes to all of above. From a

O
 
Points)
  on 2/4/12 at 6:28am

Yes to all of above. From a purely mechanical perspective, think of dividing a cash flow of $x by (1+r)^t, which is of course finding the present value. Take two cash flows, one 1 year into the future and another, say, 5 years into the future. Use some interest rate to discount them and record result. Then change the interest by a certain amount and discount the cash flows again. See which of the two cash flows had a bigger %change.