Question

From the perspective of someone holding a ten-year bond, which would have a higher net present value: a level coupon bond with a face value of $1,000 with a 2% annual coupon rate, or a zero-coupon bond with the same face value? Be sure to explain your answer, and assume coupon payments for the level coupon bond start in Year 1 (the bond is purchased in Year 0).

Answer 1

Solution-

Remember the net present value is the present value of the future cashflows. In level coupon bond, the cashflows include the coupons including $ 1000 face value at the end of 10 years. However, in zero-coupon bond, there is only one cash flow at the end of 10 years.

Net present value being the present value of these cashflows must be higher for level coupon bond because of extra coupons. The difference arises due to extra present value of coupons at the end of each of following 10 years.

Answer

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