Bond valuation
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Bond valuation is the process of determining the fair price of a bond. As with any security or capital investment, the fair value of a bond is the present value of the stream of cash flows it is expected to generate. Hence, the price or value of a bond is determined by discounting the bond's expected cash flows to the present using the appropriate discount rate.
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[edit] General relationships
[edit] The present value relationship
The fair price of a straight bond (a bond with no embedded option; see Callable bond) is determined by discounting the expected cash flows:
- Cash flows:
- the periodic coupon payments C, each of which is made n times (n is usually 2) every year
- the par or face value F, which is payable at maturity of the bond after T years.(NB final year payments will include the par value plus the coupon payments for the year)
- Discount rate: the required (annually compounded) yield or rate of return r
- r is the market interest rate for bonds with similar terms and risk ratings
- m is the number of coupons to be paid over the remaining lifetime of the bond, ie n times T. (It is assumed that the previous coupon has just been paid.)
- u is (1+r)^(1/n) ie an interest accumulation factor over one coupon period
- Bond Price =
Because the price is the present value of the cash flows, there is an inverse relationship between price and discount rate: the higher the discount rate the lower the value of the bond (and vice versa). A bond trading below its face value is trading at a discount, a bond trading above its face value is at a premium.
[edit] Coupon yield
The coupon yield is simply the coupon payment (C) as a percentage of the face value (F).
- Coupon yield = C / F
Coupon yield is also called nominal yield.
[edit] Current yield
The current yield is simply the coupon payment (C) as a percentage of the bond price (P).
- Current yield = C / P0.
[edit] Yield to Maturity
The yield to maturity (YTM) is the discount rate which returns the market price of the bond. It is thus the internal rate of return of an investment in the bond made at the observed price. YTM can also be used to price a bond, where it is used as the required return on the bond.
In other words, it is identical to r in the above equation.
To achieve a return equal to YTM, the bond owner must:
- buy the bond at price P0,
- hold the bond until maturity, and
- redeem the bond at par.
The concept of current yield is closely related to other bond concepts, including yield to maturity, and coupon yield. The relationship between yield to maturity and coupon rate is as follows:
- When a bond sells at a discount, YTM > current yield > coupon yield.
- When a bond sells at a premium, coupon yield > current yield > YTM.
- When a bond sells at par, YTM = current yield = coupon yield.
[edit] Bond pricing
[edit] Relative price approach
Here the bond will be priced relative to a benchmark, usually a government security. The yield to maturity on the bond is determined based on the bond's rating relative to a government security with similar maturity or duration. The better the quality of the bond, the smaller the spread between its required return and the YTM of the benchmark. This required return is then used to discount the bond cash flows as above to obtain the price.
[edit] Arbitrage free pricing approach
In this approach, the bond price will reflect its arbitrage free price (arbitrage=practice of taking advantage of a state of imbalance between two or more markets). Here, each cash flow is priced separately and is discounted at the same rate as the corresponding government issue Zero coupon bond. (Some multiple of the bond (or the security) will produce an identical cash flow to the government security (or the bond in question).) Since each bond cash flow is known with certainty, the bond price today must be equal to the sum of each of its cash flows discounted at the corresponding risk free rate - i.e. the corresponding government security. Were this not the case, arbitrage would be possible - see rational pricing.
[edit] See also
[edit] External links
[edit] Discussion
- Bond Price Volatility Investment Analysts Society of South Africa
- Duration and convexity Investment Analysts Society of South Africa
- Course material Fixed Income Analytics
