An Introduction to the Bond Markets

3

How Do You Price and Value a Bond?

This chapter starts by looking at the basic concept of compound interest. It then goes on to consider some of the factors that investors may want to take into account when they are purchasing or selling a bond. It describes the concept of accrued interest and how bonds are priced. This is followed by a description of redemption and other yield measures and related calculations. In order to try and make the chapter more comprehensible to non-mathematicians, most of the formulae have been relegated to Appendix B.

3.1 COMPOUND INTEREST

You have all heard the old adage that the value of a security is that price at which there are the same number of buyers as sellers. If the security is reasonably liquid, the price moves up and down in small steps according to the perception of the buyers and the sellers. Unfortunately, this does not help in the case of a bond which is illiquid and has not traded for six months. Here the last traded price may have very little relevance to what the bond is worth. Even if the perceived status and rating of the issue has not changed, its value may have changed considerably due to large swings in interest rates since the last transaction.

However, as bonds have predefined coupon and capital payments, albeit subject to a great variety of embedded options, there is an alternative approach. This approach defines the value of a bond as the discounted value of all expected future payments. The question now becomes: ‘At what ...