Question

How to determine the theoretical price of an elementary bond in finance?

Answer 1

The theoretical price of a bond is determined by calculating the present value of all future cash flows from the bond at the applicable discount rate which is the minimum required rate of return expected by bond holders on their investment. This minimum return is the YTM (Yield to maturity) of the bond or the interest rate prevailing in the market.

The cash flows from a bond can be in two forms: Coupon payments (interest) received on periodical basis (yearly, monthly, semiannually etc) and Principal repayment on maturity.

Price of a bond is calculated by the following formula:

[PMT(T1) / (1 + r)^1] + [PMT(T2) / (1 + r)^2] … [(PMT(Tn) + FV) / (1 + r)^n]

where,

• PMT(Tn) = Coupon Payment at Time N
• FV = Future Value/ Par Value
• R = Yield to Maturity or Market Interest Rate
• N = No. of Periods

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