Bond valuation is used to determine the price of a bond. Bond value is based upon the amount of cash that it could potentially generate at any given time. This is calculated by discounting the amount of cash it generates upon maturity by the discount rate. The discount rate is found by comparing it to similar rates if they are available. Embedded options in bonds also need option pricing that needs to be added or subtracted to the amount. Once the various yields are calculated, the price of the bond can be estimated.
The Types of Bonds Available
There are several different types of bonds available. This includes a pure discount bond which pays the face value of the bond upon maturity. A consol bond pays at periodic intervals and has no maturity date. A level coupon bond pays at periodic intervals and has a maturity date when the face value is paid. A callable bond allows the issuer to purchase the bond back before the bond matures at specific time periods. In addition, a convertible bond lets the owner exchange it for a specified number of stock options.
What Factors Determine a Bonds Investment Potential?
Bond valuation is only one of the factors that are used to determine an investments value though. Investors also look at the companys credit history, whether or not the bond is investment grade or junk, the appreciation anticipated and the growth prospects of the issuing company. Market interest rates are also examined by investors. After these factors are examined, it is possible to determine if a bond will provide a satisfactory rate of return.
Bond Terms to Understand
To understand how bond valuation works, investors should also understand the terminology that is used for the value. The nominal value is a fixed rate and it does not change over time. This value is printed on the face of the bond and is used to determine the principal of the bond upon maturity. The issue value may not be less than 5 percent of the nominal value and is the price of purchase on the bond. Sometimes discounts are offered if the bond is purchased later in the issue. The market value refers to the market interest rate.
Finding the Bond Valuation Inputs
In order to get a bond valuation, the calculation PV=[?CFtv(1 + i)t] + [FV/(1+i)t] is used. The five variables necessary for input are the number of cash flows (N), the amount of cash flow (PMT), the yield per six months (i), the future valuation and the present value (PV). By finding the present value it is possible to calculate the bonds value. This calculation makes the assumption that the bonds pay interest semi-annually. However, the calculation can be adjusted to find a different interest frequency.
The technique of bond valuation helps investors determine if the bond is worth the value. However, the future price of a bond is dependent on future interest rates and therefore uncertain. For this reason, the calculations may need to be adjusted to reflect different criteria and stochastic calculus may need to be used for the most accurate data.