InvestorQ : Can you explain bond pricing methodology and whether it is the price at which I shall get the bond the secondary market?
Ria Roy made post

Can you explain bond pricing methodology and whether it is the price at which I shall get the bond the secondary market?

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Mahil Khan answered.
2 years ago
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The bond pricing calculated by the discounting method gives you a theoretical value. It is like calculating the fair price of the stock or the option value through Black & Scholes. When you do that, you only get the theoretical value. The actual market price may be above or below that and that means you get an opportunity to buy or sell that bond based on whether it is under priced or overpriced. Look at the Illustration below:

Inputs

Rate Convention: 1 = EAR, 0 = APR

0

Annual Coupon Rate (CR)

8.0%

Yield to Maturity (Annualized) (y)

8.0%

Number of Payments / Year (NOP)

2

Number of Periods to Maturity (T)

8

Face Value (FV)

? 1,000

Outputs

Discount Rate / Period (RATE)

4.0%

Coupon Payment (PMT)

? 40

Calculate Bond Price using the Cash Flows

Period

0

1

2

3

4

5

6

7

8

Time (Years)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Cash Flows

? 40.00

? 40.00

? 40.00

? 40.00

? 40.00

? 40.00

? 40.00

? 1,040.00

Present Value of Cash Flow

? 38.46

? 36.98

? 35.56

? 34.19

? 32.88

? 31.61

? 30.40

? 759.92

Bond Price

? 1,000.00

In the above table, we have considered a situation where the coupon rate is the same as the yield in the market. The bond is paying annual coupon of 8% but on a half yearly basis. This makes it a half yearly coupon of 4%. Since it is a 4-year maturity bond, the investor gets 7 intermittent coupon payments of Rs.40 each and the 8th and last payment is received including the principal redemption. The coupon and the yield of similar bonds in the market is the same and hence the bond investor is largely indifferent whether he buys this bond or any other bond. That is why this bond is quoting at the same price as the face value of the bond. That means, the price of the bond varies from the face value only if the yield in the market for similar bonds is different from the coupon rate. That means if the return structure of the bond is at divergence with the market that is when the price diverges from the face value and greater is the divergence greater is the gap between market price and the coupon value.
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