Bond valuation

Bond valuation is the process by which an investor arrives at an estimate of the theoretical fair value, or intrinsic worth, of a bond. As with any security or capital investment, the theoretical fair value of a bond is the present value of the stream of cash flows it is expected to generate. Hence, the value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate.^[1]^[2]

In practice, this discount rate is often determined by reference to similar instruments, provided that such instruments exist. Various related yield-measures are then calculated for the given price. Where the market price of bond is less than its par value, the bond is selling at a discount. Conversely, if the market price of bond is greater than its par value, the bond is selling at a premium. For this and other relationships between price and yield, see below.

If the bond includes embedded options, the valuation is more difficult and combines option pricing with discounting. Depending on the type of option, the option price as calculated is either added to or subtracted from the price of the "straight" portion.^[3] See further under Bond option. This total is then the value of the bond.

^ Malkiel, Burton G. (1962). "Expectations, Bond Prices, and the Term Structure of Interest Rates". The Quarterly Journal of Economics. 76 (2): 197–218. doi:10.2307/1880816. ISSN 0033-5533. JSTOR 1880816.
^ Bodi, Zvi; Kane, Alex.; Marcus, Alan J. (2010). Essentials of Investments (eighth ed.). New York: McGraw-Hill/Irwin. ISBN 978-0-07-338240-1.{{cite book}}: CS1 maint: multiple names: authors list (link)
^ Kalotay, Andrew J.; Williams, George O.; Fabozzi, Frank J. (1993). "A Model for Valuing Bonds and Embedded Options". Financial Analysts Journal. 49 (3): 35–46. doi:10.2469/faj.v49.n3.35. ISSN 0015-198X – via Taylor & Francis.

[1] Malkiel, Burton G. (1962). "Expectations, Bond Prices, and the Term Structure of Interest Rates". The Quarterly Journal of Economics. 76 (2): 197–218. doi:10.2307/1880816. ISSN 0033-5533. JSTOR 1880816.

[bodi-2] Bodi, Zvi; Kane, Alex.; Marcus, Alan J. (2010). Essentials of Investments (eighth ed.). New York: McGraw-Hill/Irwin. ISBN 978-0-07-338240-1.{{cite book}}: CS1 maint: multiple names: authors list (link)

[3] Kalotay, Andrew J.; Williams, George O.; Fabozzi, Frank J. (1993). "A Model for Valuing Bonds and Embedded Options". Financial Analysts Journal. 49 (3): 35–46. doi:10.2469/faj.v49.n3.35. ISSN 0015-198X – via Taylor & Francis.

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