A zero coupon bond is defined as “a debt
security that does not pay back an interest (a coupon)”. But it is traded in a
stock exchange at a greater discount, generating profits at the maturity when
the bond is redeemed for its full face value. Others are bonds that are
stripped off their coupons by a financial institution and resold as a zero
coupon bond. The entire payment including the coupon at the time of maturity is
offered later. The price of zero coupon bonds have a tendency to fluctuate more
than the prices of coupon bonds (Momoh, 2018).

Yield curve is obtained by plotting the
interest rates obtained from the securities against the time (monthly, daily or
annually) for securities having different maturity dates. These plotted data
have been used in various studies to identify behavior of the securities and to
predict the future behaviors. Various studies have been conducted to
investigate the behavior of various types of treasury bonds and bills by using
the yield curve.

We Will Write a Custom Essay Specifically
For You For Only $13.90/page!

order now

The return on capital
invested in fixed income earning securities is commonly called as yield. The
yield on any instrument has two distinct aspects, a regular income in the form
of interest income (coupon payments) and changes in the market value and the
fixed income gearing securities (Thomas et al.).

Durbha, Datta Roy and
Pawaskar in their paper titled “Estimating the Zero Coupon Yield Curve” have
pointed out factors the Maturity period, Coupon rate, Tax rate, Marketability
and Risk factor, which make a yield differential among the fixed income bearing
securities. Further they have pointed out that the government securities which
are considered as the safest securities to invest also carries hidden risks as Purchasing
power risk and Interest rate risks.

According to the authors the
behavior of inflation within the country arises due to the purchasing power
risk and lead to changes in real rate of return. Interest rate risk is produced
due to the oscillations in prices of the securities. In such a case the
investors should regulate their portfolios accordingly.

Numerous contributions in finance have proved that
imposing no-arbitrage constraints in empirical models of the yield curve
improve their empirical features.