Final answer:
The difference between the price and the par value of a zero-coupon bond represents the bond's discount or premium, based on interest rate fluctuations and investor expectations.
Step-by-step explanation:
The difference between the price and the par value of a zero-coupon bond represents the bond's discount or premium. A zero-coupon bond does not pay periodic interest; instead, it is sold at a discount to its par value and matures at par value. The discount is essentially the interest that accumulates over the life of the bond.
When interest rates rise, as with the bond example where rates increase from 8% to 12%, zero-coupon bonds already in the market become less attractive because new bonds reflect the higher rate. To make the older bonds competitive, their market price must decrease to offer a similar yield to maturity that the new higher-rate bonds offer. This adjusted market price must be lower than the bond's par value to provide the same effective return on investment as newly issued bonds at the prevailing higher rates.
Investors will buy a bond at a discount to par value when they expect their yield to maturity—reflecting the accumulation of interest represented by the difference between purchase price and redemption value at maturity—to be competitive with current market interest rates. Ultimately, the value of a bond, either at a premium or at a discount, is determined by its present value, which is the present value of the stream of future expected payments discounted at the current market interest rate.