Bond valuation: Encyclopedia II - Bond valuation - Bond pricing

Bond valuation - Bond pricing

Bond valuation - Relative price approach

Here the bond will be priced relative to a benchmark, usually a government security. The discount rate used to value the bond is determined based on the bond's rating relative to a government security with similar maturity. 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.

Bond valuation - Arbitrage free pricing approach

In this approach, the bond price will reflect its arbitrage free price. 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.

Here the discount rate per cash flow, r_t, must match that of the corresponding zero coupon bond's rate.

Adapted from the Wikipedia article "Bond pricing", under the G.N U Free Docmentation License. Please also see http://en.wikipedia.org/wiki