How To Price A Bond
This tutorial will give you step by step instructions on how to price a bond. If you were thinking of investing in bonds or looking to learn how to price a bond for your class, you’ve come to the right place! (There is a spreadsheet bond price calculator at the end of the tutorial)
Individual investors and companies that are fortunate enough to have excess cash sitting around may invest in debt securities that are either issued by the government or other private entities. Issuance of a bond is usually done by large organizations and governments. These organizations issue bonds because they have a financing need to improve their overall cash position.
Investors are attracted to bond investments because it allows them to generate interest income and are usually much less riskier than equities investments. That’s why knowing how to price a bond can help you evaluate potential offerings that may be of interest.
How To Price A Bond:
Before going through any type of exercise, it benefits to become familiar with some important concepts and terminology as it relates to this topic, so that you can understand how to price a bond with more ease. (Also take note that this is a shared topic that lends itself to finance and accounting) Specifically, you will want to understand the various elements of a bond in addition to concepts related to the time value of money.
Let’s begin by asking, what is a bond?
A bond is a debt instrument issued by organizations that promise the bearer a lump sum payment at maturity in addition to periodic interest payments until the bond becomes mature. A bond will have:
- Information about the issuer and a guarantee to pay at maturity
- A face value: the value printed on the bond representing what the bond can be redeemed for at maturity (i.e., $10,000)
- A stated interest rate: the annual rate at which cash will be paid periodically for the term of the bond. (i.e., 12% annually)
- The term or duration of the bond. (i.e., 10 years)
- Information about how often interest will be paid. (i.e., monthly, semi-annually, annually).
How are bonds issued?
Bonds can be issued in 3 distinct ways:
- At par value: the bond is issued or sold for its face value
- At a discount: the bond is issued or sold for less than its face value
- At a premium: the bond is issued or sold at higher than face value
What determines the selling price of the bond?
The key variable that ultimately decides whether a bond will be issued at par value is the market interest rate, also known as the effective interest rate. The market rate is the prevailing rate for similar bonds with similar risks at the time the bond is issued.
When the market rate is:
- Equal to the stated interest rate of the bond, it will sell at face value.
- Greater than the stated interest rate of the bond, it will sell at a discount.
- Less than the stated interest rate of the bond, it will sell at a premium.
How to price a bond if the stated interest rate and market interest rate are different:
Determining the issue price requires an understanding of the time value of money. Generally speaking it should make sense that $100 is worth more today than a $100 a year from now. The reason is that the $100 today carries more purchasing power or can be invested for a return on principal. So it helps to look at future income in terms of what it is worth today. When one looks at money from this perspective they are essentially evaluating the investment in terms of what is known as present value (PV).
Determining present value is a very objective exercise and is backed by standard schedules / charts (Time value of money tables) that have defined values one should use in their calculations. How those values were determined are beyond the scope of this discussion and so it is not something to be concerned with at this point.
For the purpose of learning how to price a bond, it is essential to understand that a bond has two different monetary elements. One is the lump-sum amount the bearer will redeem (the face value of the bond) and the other is the annuity (or periodic) cash payments made to the bearer for the term duration.
In order to determine: (Continue Reading)
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