CHAPTER 2Valuation: Fundamentals of Fixed-Income and Non-Maturing Products

Intrinsic, theoretic, or economic value of a financial instrument is the present value of the future cash flows expected from the instrument. Valuation date is the date that cash flows are discounted back. The interest rate used in discounting the future cash flows is selected such that it captures the current market condition, as well as expectation of the future interest rate environment. Those rates should be adjusted for the riskiness of the instrument. Theoretical values of two financial instruments with identical contractual future cash flows are not the same; if one is perceived to have higher risk, such as counterparty default risk, compare to the other.

Many financial instruments, such as bonds and stocks, are actively traded in their associated markets. The market value of a financial instrument is the price that market participants are willing to trade the instrument. A bid price is the maximum price a market participant is willing to pay to buy the instrument and an ask price is the minimum price at which a market participant is accepting to sell the instrument. Market prices depend on the supply and demand forces, as well as economy and political environments, and fluctuate from one day to another or even during a trading day. Often news about a company, its customers, or its suppliers affects prices of financial securities associated with that firm. For these reasons, market value and economic ...

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