Finance

Bond Pricing

Bond Pricing

An instrument of indebtedness of the bond issuer to the holders is known as a bond. An organization can raise capital in financial markets either by issuing shares or by issuing bonds. A bond is a debt instrument in which an investor borrows money from the issuer for a specified period of time. They are typically issued by corporations, municipalities, states/provinces, and countries to fund a wide range of projects and activities. It is the issuer generally who sets the price and yield of the bond so as to supply the amount it desires by selling bonds. The total return expected on the maturity of a bond is called Yield to Maturity.

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What is Bond Pricing?

Bond pricing is a method of calculating a bond’s issue price based on its coupon, yield, par value, and term of maturity. It is the sum of present values of all likely coupon payments plus the present value of par value at maturity. A par value of the bond is the percentage of the bond’s principal balance. Bonds trade at a premium if the current price is higher than the face value and at a discount when the current price is lower than the face value of the bond.

Factors considered in Bond Pricing?

  1. Par-Value
  2. Coupon Rate
  3. Prevailing Interest Rates
  4. Accrued Interest
  5. Credit Rating of the Issuer
  6. Supply and demand
  7. Term to maturity.

Formula & Example:

The bond pricing mechanism is essentially the current value estimation of likely potential cash flows, including coupon payments, and the par value, which is the maturity redemption amount. The formula to calculate a bond price is:

 

 

 Bond Price= ∑ (Cn / (1+I) n) + P / (1+I) n

Where,

  • n = no of years
  • C= Coupon payment in the nth period
  • YTM / r/ I = interest rate or required yield
  • P = Par Value of the bond

     Examples:

  1. Let’s price a bond whose par value is $500; the coupon rate is 10% and YTM is 6%. The bond matures after 4 years.

P = 500$

C = 50

YTM = 6%

N = 4

Bond Price= ∑ (Cn / (1+I) n) + P / (1+I) n

Bond Price = 50 / (1.06) + 50 / (1.06) ^2 + 50 / (1.06) ^3 + 50 / (1.06) ^4 + 500 / (1.06) ^ 4

= 47.16+ 44.49+ 42.02+ 39.68+396.82

Bond Price = 570.17$

  1. Alicia & Co issues zero coupon bonds having a Face Value of $1000. The YTM is 5% and the bond matures in 5 Years. Find the bond price.

C= 0

P= 1000$

YTM= 5%

N= 5

Zero-Coupon Bond price = P/ (1+ I ) n

                                                                   = 1000 / (1+ 0.05) ^5

                                                                   = 1000 / (1.05) ^ 5

                                                                   = 1000 /1.28

Zero-Coupon Bond Price   = 781.25$

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The relevance of Bond Pricing in Financial Markets

This concept is very important as bonds are an important part of the capital market and bond pricing helps investors and analysts understand how various factors affect the prices of the bond and how the bonds behave. It is also helpful in understanding whether the investment is suitable for a portfolio and thus becomes an integral part of bond investing.

Author: Urvi Surti

About the Author: Urvi is a commerce graduate and has a keen interest in Finance. She has completed her Chartered Wealth Management (CWM) from the American Academy of Financial Management and is currently pursuing a career in Financial Risk Management (FRM).

 

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