Handbook of Finance: Valuation, Financial Modeling, and Quantitative Tools

Chapter 36. General Principles of Bond Valuation

FRANK J. FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

STEVEN V. MANN, PhD

Professor of Finance, The Moore School of Business, University of South Carolina

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.

Keyword: option-free bond, full price, clean price, pull to par value, arbitrage-free valuation approach, spot rate, spot rate curve, bootstrapping, benchmark spot rate curve, benchmark zero-coupon rate curve

Valuation is the process of determining the fair value of a financial asset. In this chapter, we will explain the general ...