Bond Valuation - Bond Valuation

Bond Valuation

As above, the fair price of a "straight bond" (a bond with no embedded options; see Bond (finance)# Features) is usually determined by discounting its expected cash flows at the appropriate discount rate. The formula commonly applied is discussed initially. Although this present value relationship reflects the theoretical approach to determining the value of a bond, in practice its price is (usually) determined with reference to other, more liquid instruments. The two main approaches, Relative pricing and Arbitrage-free pricing, are discussed next. Finally, where it is important to recognise that future interest rates are uncertain and that the discount rate is not adequately represented by a single fixed number - for example when an option is written on the bond in question - stochastic calculus may be employed.

Where the market price of bond is less than its face value (par value), the bond is selling at a discount. Conversely, if the market price of bond is greater than its face value, the bond is selling at a premium. For this and other relationships relating price and yield, see below.