Looking for the answer to the question below related to Financial Management ?
Zero coupon bonds mean
|A. Fixed rate of interest
B. Zero rate of interest
C. Higher rate of interest
D. None of these
The Correct Answer Is:
- B. Zero rate of interest
Zero-coupon bonds, also known as zero-coupon securities or discount bonds, are a type of bond that pays no periodic interest (coupon) during its life. Instead, they are issued at a discount to their face value and then redeemed at face value upon maturity. The correct answer to the question is option B: “Zero rate of interest.” Let’s delve into the details of why this answer is correct and why the other options are not:
Option A: “Fixed rate of interest”
This option is not correct because zero coupon bonds do not pay any fixed rate of interest. Unlike traditional bonds, which make periodic interest payments to bondholders, zero coupon bonds are issued at a discount to their face value and provide no interest payments until maturity.
Investors profit from the difference between the purchase price and the face value when the bond matures, effectively earning their interest through capital appreciation.
Option C: “Higher rate of interest”
This option is also incorrect because it doesn’t accurately describe zero coupon bonds. Zero coupon bonds do not offer a higher rate of interest compared to other bonds. In fact, their distinguishing feature is the absence of periodic interest payments.
Instead of receiving interest income, investors in zero coupon bonds receive their returns in the form of capital gains as the bond’s value increases over time, approaching its face value at maturity.
Option D: “None of these”
This option is not the correct answer because, as explained above, option B (Zero rate of interest) accurately characterizes zero coupon bonds. While option A implies a fixed rate of interest, option C suggests a higher rate of interest, both of which are inaccurate in the context of zero coupon bonds.
Zero coupon bonds are essentially issued at a discounted price, and their value gradually appreciates over time, moving towards their face value at maturity. The difference between the purchase price and the face value represents the investor’s return, and this return is not paid out as periodic interest but rather as a lump sum at the bond’s maturity.
Investors are attracted to zero-coupon bonds for several reasons:
Certainty of Returns: Zero coupon bonds provide a predictable return because investors know the exact amount they will receive at maturity. There is no variability in interest payments.
Tax Efficiency: Since there are no periodic interest payments, investors can defer their tax liability until the bond matures. This can be advantageous for investors in higher tax brackets.
Capital Appreciation: Zero coupon bonds often sell at a significant discount to their face value, which means investors have the potential for substantial capital appreciation as the bond approaches maturity.
Diversification: Investors often use zero-coupon bonds as a way to diversify their portfolios. They can be particularly attractive for long-term financial goals, such as retirement planning or funding a child’s education.
In conclusion, zero coupon bonds are financial instruments that do not provide a fixed or variable interest rate, and they are not associated with a higher interest rate. Instead, they are issued at a discount and pay no periodic interest.
The correct characterization of zero coupon bonds is “Zero rate of interest,” as they offer no interest payments during their life but provide returns through capital appreciation and redemption at face value upon maturity.