Basics of Bond Valuation
Abstract: The value of any financial asset is the present value of its expected future cash flows. To value a bond, one must be able estimate the bond’s remaining cash flows and identify the appropriate discount rate(s). The traditional approach to bond valuation is to discount every cash flow with the same discount rate. Simply put, the relevant yield curve used in valuation is assumed to be flat. This approach permits opportunities for arbitrage. Alternatively, the arbitrage-free valuation approach starts with the premise that a bond should be viewed as a portfolio or package of zero-coupon bonds. Moreover, each of the bond’s cash flows is valued using a unique discount rate that depends on the shape of the yield curve and when the cash flow is delivered in time. The relevant set of discount rates (that is, spot rates) is derived from the Treasury yield curve and when used to value risky bonds augmented with a spread.
Valuation is the process of determining the fair value of a financial asset. In this entry, we will explain the general principles of bond valuation. Our focus will be on how to value option-free bonds (that is, bonds that are not callable, putable, or convertible). A special analytical framework is required to value more complex bond structures such as bonds that ...
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