Introduction to Fixed Income Analytics: Relative Value Analysis, Risk Measures, and Valuation, Second Edition

CHAPTER 4

Valuation of Option-Free Bonds

Valuation is the process of determining the fair value of a financial asset. Once this process is complete, we can compare a financial asset’s fair value to its market price to determine whether it is overvalued (i.e., rich) or undervalued (i.e., cheap). After this comparison, we can then take the appropriate position (short or long) in order to benefit from any differences. In well-functioning markets, however, fair values and market prices should be reasonably close.

In this chapter, we explain the general principles of fixed income security valuation. We confine the discussion in this chapter to the valuation of option-free bonds. Models for valuing bonds with embedded options will be described in Chapters 7 and 9.

GENERAL PRINCIPLES OF VALUATION

The fundamental principle of valuation is that the value of any financial asset is equal to the present value of its expected future cash flows. This principle holds for any financial asset from zero-coupon bonds to interest rate swaps. Thus, the valuation of a financial asset involves the following three steps:

Step 1: Estimate the expected future 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 future cash flows found in Step 1 by the appropriate interest rate or interest rates determined in Step 2.

Estimating Cash Flows

Cash flow is simply the cash that is ...