Bond Valuation

Bond valuation is done to determine the right value of a certain bond. To determine the fair price of a bond, just like in other capital or security investment, the present value of the bond is determined along with the stream of cash inflow that it is expected to generate for the investor. In order to known the value of the bond in bond valuation, the expected cash flow of the bond is discounted to the present value and is computed using the most suitable discount rate.

There are two know approaches in bond valuation. The first approach in bond valuation is the relative price approach. In this case, the price of the bond is determined relative to a benchmark, which is usually a government security. The yield during the maturity of the bond is determined based on its rating compared with a government security with the same duration or maturity. The computed required return will be used to discount the cash flows of the bond to determine the price of the bond.

The second approach in bond valuation is through arbitrage-free pricing approach. Knowing that arbitrage is the taking advantage of a market imbalance, through this method, the cash flow is separately priced and the rate of discount is the same as that of a government issued zero coupon bonds. Because the cash flow of the bond is known, the present price of the bond will be equal to the sum of the cash flows with the discount computed at the risk-free rate.