How does a zero-coupon bond typically behave in relation to interest rate changes?

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A zero-coupon bond is a type of bond that does not make periodic interest payments, or coupons, and instead is sold at a discount to its face value. The investor receives the face value at maturity, which represents the bond's yield. When it comes to interest rate changes, zero-coupon bonds exhibit a clear behavior: the price of these bonds moves inversely to changes in interest rates.

When market interest rates rise, newer bonds are issued at higher rates, which makes existing zero-coupon bonds, which are paying lower yields, less attractive. To account for this discrepancy, the market price of existing zero-coupon bonds falls. Conversely, when interest rates drop, the price of existing zero-coupon bonds would increase, as their fixed face value becomes more appealing relative to new bonds with lower interest rates.

Due to their long duration relative to traditional coupon bonds, zero-coupon bonds tend to be more sensitive to interest rate changes. Thus, their prices exhibit this inverse relationship as a fundamental characteristic of their structure. This phenomenon makes zero-coupon bonds a notable example within fixed-income securities, clearly demonstrating the impact of interest rate fluctuations on bond pricing.

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