Bond Valuation

By-
Anurag Chauhan (500093488)
Aman Saxena (500089456)
Alabhya Grover

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Definition of 'Bond’
❑ A debt investment in which an investor loans money to an
entity (corporate or governmental) that borrows the funds
for a defined period of time at a fixed interest rate. Bonds
are used by companies, states and foreign governments to
finance a variety of projects and activities.
❑ Government companies and the government issue bonds
and borrow money from people or institutions. So, public
is the lender of money and government companies are
the
 borrowers. So, a bond can again be defined as a
contract that requires the borrower to pay interest income
to the
lender.

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A technique for determining the fair value of a
particular bond. Bond valuation includes calculating
the present value of the bond’s future interest
payments, also known as it’s cash flow, and the bond’s
value upon maturity, also known as its face value or
par value.
 Face or Par Value- The amount of money that is paid to the
bondholders at maturity. For most bonds this amount is
Rs.1000, Rs.2000, Rs.5000 and so on. It indicates the value
of the bond i.e, the value stated on bond paper.
 Coupon rate- The coupon rate, which is generally fixed,
determines the periodic coupon or interest payments. It is
expressed as a percentage of the bond’s face value. It also
represents the interest cost of the bond of the issuer.
Features of Bonds

A sealed agreement
Repayment of principles
Specified time period
Interest payment
Call and options

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Risk in Bonds-
• Interest rate risk- Variability in the return from debt instruments
to investors is caused by the changes in the market interest
rates. This is known as interest rate risk.
• Default risk- The failure to pay the agreed value of the debt
instrument by the issuer in full, on time are called so. It is due
to the macro economic factors or firm specific factors.
• Marketability risk- Variation in returns caused by difficulty in
selling bonds quickly without having to make a substantial price
concession is known as marketability risk.
• Callability risk- The uncertainty created in the investor’s return
by the issuer’s ability to call the bond at any time is known as
callability risk. Debt instruments used to carry a call option, this
option provides the issuer the right to call back the instruments
by redeeming them. Since the bond or debenture can be called
at any time there is uncertainty regarding the maturity period.
This feature of the bond may depress the price level of the
bond.
Steps for Valuation of Bonds

 Step 1- Estimating cash flows

Cash flow is the cash that is estimated to be received in the
future from investment in a bond. There are only two types
of cash flows that can be received from investment in bonds,
i.e., coupon payments and principal payments at maturity.
The usual cash flow cycle of the bond is coupon payments
are received at regular intervals as per the bond agreement,
and the final coupon plus principle payment is received at
maturity. There are some instances when bonds don’t follow
these regular patterns. Unusual patterns may be a result of
the different types of bonds, such as zero-coupon bonds, in
which there are no coupon payments. Considering such
factors, it is important for an analyst to estimate accurate
cash flow for the purpose of bond valuation.
 Step 2 Determine the appropriate interest rate to discount the cash
flows
Once the cash flow for the bond is estimated, the next step is to
determine the appropriate interest rate to discount cash flows. The
minimum interest rate that an investor should require is the interest
available in the marketplace for default-free cash flow. Default-free
cash flows are cash flows from debt security that are completely safe
and have zero chances of default. The central bank of a country
usually issues such securities. For example, in the USA, it is bonds by
U.S. Treasury Security. Consider a situation where an investor wants
to invest in bonds. Suppose he is considering to invest corporate
bonds. In that case, he is expecting to earn a higher return from
these corporate bonds compared to the rate of returns of U.S.
Treasury Security bonds. This is because the chances are that a
corporate bond might default, whereas the U.S. Security Treasury
bond is never going to default. As he is taking a higher risk by
investing in corporate bonds, he expects a higher return.
 Step 3 Discounting the Expected Cash Flows
Now that we already have values of expected future cash flows and
the interest rate used to discount the cash flow, it is time to find
the present value of cash flows. The present value of a cash flow is
the amount of money that must be invested today to generate a
specific future value. Present value of a cash flow is more
commonly known as discounted value.
 The present value of a cash flow depends on two determinants:
• When a cash flow will be received, i.e., the timing of a cash flow
&;
• The required interest rate, more widely known as Discount Rate
(rate as per Step-2)
First, we calculate the present value of each expected cash flow.
Then we add all the present individual values and the resultant sum
is the value of the bond.
Why Bond Valuation?

Many factors, such as inflation, the credit rating of the

bonds, etc., affect the value of bonds. Furthermore,
there are many features of the bond itself that
determine its intrinsic value. As an investor, it is
important to be fully aware of what we are investing in,
what are the risks involved, and how much returns we
can expect. Bond valuation tries to consider all the
features to determine an accurate present value. This
present value can be very helpful for investors &
analysts to make an informed investment decision.
Thank You