Bond valuation: Encyclopedia II - Bond valuation - General relationships

Bond valuation - General relationships

Bond valuation - The present value relationship

The fair price of a straight bond (a bond with no embedded option) is determined by discounting the expected cash flows:

• Cash flows:
  • the periodic coupon payments C, each of which is made every t periods;
  • the par or face value F, which is payable at maturity of the bond after T periods.

• Discount rate: the required (annually compounded) yield or rate of return r.
  • r is the market interest rate for new bond issues with similar risk ratings

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.

Bond valuation - Coupon yield

The coupon yield is simply the coupon payment as a percentage of the face value.

Bond valuation - Current yield

The current yield is simply the coupon payment as a percentage of the bond price.

Bond valuation - 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.

To achieve a return equal to YTM, the bond owner must invest each coupon received at this rate.

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