Why is a zero coupon bond more sensitive to interest rates than just a coupon bond?
It doesnt really make sense to me, any ideas? thanks!
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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.
Got it! Thanks!!!!
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
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