2) Key Bond Characteristics
By Roshan Waingankar Leave a Comment. Risk Management Basics.
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The formula for bond pricing is basically the calculation of the present value of the probable future cash flows which comprises of the coupon payments and the par value which is the redemption amount on maturity. The rate of interest which is used to discount the future cash flows is known as the yield to maturity YTM.source
BAII Plus Bond Valuation | ujopaducivys.gq
On the other, the bond valuation formula for deep discount bonds or zero coupon bonds can be computed simply by discounting the par value to present value which is mathematically represented as,. Step 1: Firstly, the face value or par value of the bond issuance is determined as per the funding requirement of the company. The par value is denoted by F. Step 2: Now, the coupon rate, which is analogous to interest rate, of the bond and the frequency of the coupon payment is determined.
The coupon payment during a period is calculated by multiplying coupon rate and the par value and then dividing the result by the frequency of the coupon payments in a year.
The coupon payment is denoted by C. Step 3: Now, the total number of periods till maturity is computed by multiplying the number of years till maturity and the frequency of the coupon payments in a year. The number of periods till maturity is denoted by n. Step 4: Now, the yield to maturity YTM is the discounting factor and it is determined based on the current market return from an investment with similar risk profile.
The number of periods till maturity is denoted by n. Step 4: Now, the yield to maturity YTM is the discounting factor and it is determined based on the current market return from an investment with similar risk profile.
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The YTM is denoted by r. Step 5: Now, the present value of the first, second, third coupon payment and so on so forth along with the present value of the par value to be redeemed after n periods is derived as,. Step 6: Finally, adding together the present value of all the coupon payments and the par value gives the bond price as below,.
Below are some of the Examples of Bond Pricing Formula.
Zero Coupon Bond Value
Let us take an example of a bond with annual coupon payments. Since the coupon rate is lower than the YTM , the bond price is less than the face value and as such the bond is said to be traded at discount. Let us take an example of a bond with semi-annual coupon payments.
Since the coupon rate is higher than the YTM, the bond price is higher than the face value and as such, the bond is said to be traded at a premium. Let us take the example of a zero coupon bond.
The concept of bond pricing is very important because bonds form an indispensable part of the capital markets, and as such investors and analysts are required to understand how the different factors of a bond behave in order to determine its intrinsic value. Similar to stock valuation, the pricing of a bond is helpful in understanding whether it is a suitable investment for a portfolio and consequently forms an integral part of bond investing.
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