Bond valuation is the process of determining the fair price of a bond. As with any security or capital investment, the fair value of a bond is the present value of the stream of cash flows it is expected to generate. Hence, the price or value of a bond is determined by discounting the bond's expected cash flows to the present using the appropriate discount rate.
BOND PRICING
Relative Price Approach
Here the bond will be priced relative to a benchmark, usually a government security. The yield to maturity on the bond is determined based on the bond's rating relative to a government security with similar maturity or duration. The better the quality of the bond, the smaller the spread between its required return and the YTM of the benchmark. This required return is then used to discount the bond cash flows as above to obtain the price.
Arbitrage-Free Pricing Approach
In this approach, the bond price will reflect its arbitrage free price. Here, each cash flow is priced separately and is discounted at the same rate as the corresponding governments issue Zero coupon bond. (Some multiple of the bond (or the security) will produce an identical cash flow to the government security (or the bond in question).) Since each bond cash flow is known with certainty, the bond price today must be equal to the sum of each of its cash flows discounted at the corresponding risk free rate - i.e. the corresponding government security. Was this not the case, arbitrage would be possible.
BOND PRICING
Relative Price Approach
Here the bond will be priced relative to a benchmark, usually a government security. The yield to maturity on the bond is determined based on the bond's rating relative to a government security with similar maturity or duration. The better the quality of the bond, the smaller the spread between its required return and the YTM of the benchmark. This required return is then used to discount the bond cash flows as above to obtain the price.
Arbitrage-Free Pricing Approach
In this approach, the bond price will reflect its arbitrage free price. Here, each cash flow is priced separately and is discounted at the same rate as the corresponding governments issue Zero coupon bond. (Some multiple of the bond (or the security) will produce an identical cash flow to the government security (or the bond in question).) Since each bond cash flow is known with certainty, the bond price today must be equal to the sum of each of its cash flows discounted at the corresponding risk free rate - i.e. the corresponding government security. Was this not the case, arbitrage would be possible.
No comments:
Post a Comment