The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

BASIC VALUATION OF OPTION-FREE BONDS

The price of any financial instrument is equal to the present value of the expected cash flows from the financial instrument. Therefore, determining the price requires: (1) an estimate of the expected cash flows and (2) an estimate of the appropriate required yield. The expected cash flows for some financial instruments are simple to compute; for others, the task is more difficult. The required yield reflects the yield for financial instruments with comparable risk.

The first step in determining the price of a bond is to estimate its cash flow. The cash flow for a bond that the issuer cannot retire prior to its stated maturity date (that is, an option-free bond) consists of:

1. Periodic coupon interest payments to the maturity date.

2. The par value at maturity.

Our illustrations of bond pricing use three assumptions to simplify the analysis:

1. The coupon payments are made every six months. (For most U.S. bond issues, coupon interest is in fact paid semiannually.)

2. The next coupon payment for the bond is received exactly six months from now.

3. The coupon interest is fixed for the term of the bond.

While our focus in this chapter is on option-free bonds, in Chapter 18 we explain how to value bonds with embedded options.

Consequently, the cash flows for an option-free bond consist of an annuity of a fixed coupon interest payment paid semiannually and the par, or maturity, value. For example, a 20-year bond with a 10% coupon rate and ...