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Bond Valuation

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Bond Valuation
By Anuj Joshi

Note 1
Bond Valuation Fixed income paying securities. 1. Theoretical price or value of bond depends upon.
i. Coupon Payment : Fixed amount of interest to be received after prescribed frequency. ii. Maturity Value [Unless otherwise given is exam, we should take face value] iii. Discount Rate : It should always be market interest rate

2. What is market interest rate Market interest rate is derived from comparable listed bond. The comparison is based on risk and life of the bond. E.g. If we are valuing a bond which is unlisted and have 5 years of life, then we should look for a bond which is similar in risk profile (i.e. same credit rating)and having similar life. The YTM (Yield to Maturity) of listed bond is called market interest rate The YTM of a bond is nothing but IRR of the bond.

3. Value of a bond = PV of Coupon Amount + PV of Maturity Value [Remember CF and discount rate are before tax]

Concept Point: i. Coupon rate is a historical rate and should never be used as a discount rate. In exam, if no other information is available, then only we should assume coupon rate of interest as market rate of interest. ii. Remember, Cost of Capital or Discount Rate is a future concept and it represents opportunity cost on the date of valuation. iii. YTM of a similar bond (i.e. current market interest rate) is the appropriate discount rate for bond valuation.

How to value a bond which pays interest at a frequency lower than annually (e.g. half yearly, quarterly, etc) Three adjustments is required: i. Periodic Coupon Amount ii. Periodic Market Interest Rate iii. Revise the Period = Total number of coupon payment

E.g. Face Value = Rs 1000 Maturity = 10 Yrs Coupon Rate = 10% Required rate of interest 12% Coupon payment semi-annually

Soln, Periodic coupon amt = 1000 X 10% 2 = 50 Periodic market interest = 12% 2 = 6%

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