Question

What is a Bond? How is its price calculated?

Answer 1

~ A bond is a financial instrument that is used by the corporates and the government to generate funds of various business purposes which can include an acquisition of a new company, setting up a new business unit, purchase of a new plants, other expansion purposes.

~ A bond is much cheaper source of finance that the other sources such as equity because it has a fixed coupon rate which provides a tax saving to the issuer of such bond.

~ An issuer of a bond has to pay fixed periodic coupons and a maturity value/redemption value at the end of the maturity period of such bond.

~ A Bond Price is computed by adding up all the future benefits (in the form of Coupons and Redemption Value) that a bond holder derives from such bond during its holding priod.

~ The periodic coupons and the redemption value are discounted at the Yield to maturity (YTM) of such bonds. Now, the YTM depends on the prevailing market interest rates and several other factors.

Bond Price = Present Value of Coupons + Present Value of Redemption Value

~ The Price calculated using above method is the Fair Theoretical Price which is then compared with the actual prevailing market price to find out whether the Bond is UnderPriced or OverPriced in the market.

~ The price calculation helps an investor to take a decision that whethr he should hold the bond or buy the bond or sell the bond.