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Bonds: Pricing

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In all probability you will never have to price a bond in your life. What is more, even if you do, there are calculators designed to nothing but price bonds. However, it is worth knowing the principles behind bond pricing in order to get a better idea of how price and yield are related.

In contrast to equity the value of a bond is relatively easier to determine because the size and pattern of cash flows over a bond's life are usually known.

For example, consider the following fictional Unicorp bond trading in the domestic US secondary market on May 1st 2000.

Unicorp will pay the bondholder half of the nominal annual coupon every six months for the remaining life of the bond.

In addition, there is a promise to pay the US$10,000 principal at maturity in the year 2020.

Therefore, assuming the borrower does not default, the investor knows exactly what payments to expect and when.

However, what an investor wants to know in addition to this is: what price should I pay today for this bond? What is this bond worth today?

Present Value

The value of an asset today is not simply the sum of the future cashflows it generates, but rather the sum of the present value of those cashflows.

The present value of US$300 received six months from today is greater than the present value of US$300 received six years from today.

In fact each coupon payment of US$300 will have a different present value, the amount decreasing the further into the future we go.

The value or price of the asset is the sum of all these present values, together with the present value of the final repayment of principal.

       

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