Question by Ponchik: Why are zero-coupon bonds usually priced using a semiannual interest rate rather than annual?
Why are zero-coupon bonds usually priced with a semiannual interest rate as a discount rate rather than annual? I mean, since there are no actual coupons anyway, why use semiannual discounting? Is this some sort of ‘tradition’ or is there a technical explanation to that?
Answer by John W
As you’ve noted, zero coupon bonds have no interest coupons and hence no interest payments however they do have an overall yield over the life of the bond due to the discounted market price when compared to the redemption value at maturity. Such bonds are often competing with normal bonds that often have semiannual coupons which are often marketed by their semi-annual rates so for effective comparison, a fictitious semiannual coupon rate is calculated that would result in the same overall yield in order to compare apples with apples.
The technical reason is that people are idiots and don’t realize the differences between what they are comparing.
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