Fixed Income Analysis, Second Edition

CHAPTER 5

INTRODUCTION TO THE VALUATION OF DEBT SECURITIES

I. INTRODUCTION

Valuation is the process of determining the fair value of a financial asset. The process is also referred to as “valuing” or “pricing” a financial asset. In this chapter, we will explain the general principles of fixed income security valuation. In this chapter, we will limit our discussion to the valuation of option-free bonds.

II. GENERAL PRINCIPLES OF VALUATION

The fundamental principle of financial asset valuation is that its value is equal to the present value of its expected cash flows. This principle applies regardless of the financial asset. Thus, the valuation of a financial asset involves the following three steps:

Step 1: Estimate the expected cash flows.

Step 2: Determine the appropriate interest rate or interest rates that should be used to discount the cash flows.

Step 3: Calculate the present value of the expected cash flows found in step 1 using the interest rate or interest rates determined in step 2.

A. Estimating Cash Flows

Cash flow is simply the cash that is expected to be received in the future from an investment. In the case of a fixed income security, it does not make any difference whether the cash flow is interest income or payment of principal. The cash flows of a security are the collection of each period’s cash flow. Holding aside the risk of default, the cash flows for few fixed income securities are simple to project. Noncallable U.S. Treasury securities have known ...