What is Bond Valuation and How is it Calculated ?
One of the Most Important Uses of Discounting
The present value of a bond is the sum of all the future cash flows that can be derived from it. In this sense, the valuation of bonds really becomes simple, isnt it? All we need to do is find out the future stream of payments that are due on the bond and then find out their present value and we call find out what the valuation of that bond is. Well, this may be theoretically this simple.
However, in practical life estimating the parameters like discount rate which go into the calculation can be very difficult. Also, using different discount rates can cause us to come up with very different valuations. So, bond valuation really is a game about guessing what the future discount rate will be.
Now, lets have a look at a theoretical example of bond valuation. Here is a step by step procedure of how the calculation must be done:
The calculation of the present value of the bond is done in two components. They are as follows:
The final step is to add the present value of the annuity as well as of the lump sum payment. This adds the present values of the interest payments as well as the principal payments. Hence, we get the present value of the bond.
Lets find the present value of a bond whose face value is $100. Interest rate is 12% on an annual basis. The bond will make semi-annual interest payments for 10 years after which the principal has to be repaid and the bond expires.
Present Value of Interest Payments
Number of periods = 20 periods (10 years, however the payment is semi-annual)
Discount Rate = 6% per period (Since we have doubled the number of periods, we need to cut the discount rate into half)
Payment: $6 per period (6% * face value of $100)
Therefore, present value of the annuity equals $68.82. This is the present value of the interest payments due.
Present Value of Principal Due
The principal that needs to be repaid is $100. It needs to be repaid after 20 periods and the discount rate we are considering is 6% per period. The present value of the principal therefore is $31.18
To find the present value of the bond we need to add $68.82 + $31.18. In this case, this adds up to $100. Therefore the present value of the bond is $100.
It must, however be noted that in real life bond values swing based on the expectation of what the future discount rate will be like. It is not really the current discount rate which determines the bond value!
- What is Annuity ?
- Ordinary Annuity vs. Annuity Due
- Types of Annuity Calculations
- Bond Market Conventions
- How Interest Rates Affect Bonds ?
Authorship/Referencing - About the Author(s)
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