A:

The difference between a zero-coupon bond and a regular bond is that a zero-coupon bond does not pay coupons, or interest payments, to the bondholder while a typical bond does make these interest payments. The holder of a zero-coupon bond only receives the face value of the bond at maturity. The holder of a coupon paying bond receives the face value of the bond at maturity but is also paid coupons over the life of the bond.

Zero-coupon bondholders gain on the difference between what they pay for the bond and the amount they will receive at maturity. Zero-coupon bonds are purchased at a large discount, known as deep discount, to the face value of the bond. A coupon-paying bond will initially trade near the price of its face value. In other words, a zero-coupon bond gains from the difference between the purchase price and the face value, while the coupon bond gains from the regular distribution of interest.

For example, imagine that you have the choices between a one-year zero-coupon bond with a face value of \$1,000, which can be purchased for \$952.38 or a one-year 5% semi-annual coupon bond trading at its face value of \$1,000. If you bought the zero-coupon bond for \$952.38, you would receive \$1,000 at maturity, which is a gain of 5% (\$47.62/\$952.38). If you bought the coupon bond, you would have received two coupon payments of \$25 each during the year for a total of \$50, which also represents a 5% gain (\$50/\$1,000). So in this case, no matter which bond you buy, you will get the same return, even though the source of the return is different. This is not always true, as each case is different.

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