Zone1 ?
The price of a bond is determined by the value of its future cash
flows. These are discounted by the current interest rate. In the
example that you?ve given, the bond has a one-time coupon of $100 at
the end of the year, plus repayment of the $1,000 principal.
In other words, if interest rates were 10%, what would you be willing
to pay to get $1,100 a year from now? It turns out that $1,000 would
provide interest of $100 ? getting you back to $1,100 exactly.
There?s an excellent explanation by Rick Mathis on this page and it
includes a bond calculator:
Prentice Hall ? Corporate Finance Live
"Bond Valuation" (Mathis, 2000)
http://www.prenhall.com/divisions/bp/app/cfldemo/BV/BondValuation.html
There?s a possibility that I?ve misunderstood the exact payments laid
out in your question: I?ve assumed that the investor here gets $1,100
at the end of a year ? and that the "coupon" is paid when the bond is
repaid. More typically a bond would be priced WITHOUT a coupon for
this short a period -- these are called "zero coupon" bonds.
If you?d intended to know how the bond would be priced if it returns $1,000
TOTAL at the end of the year, the correct answer is:
$1000 * (1/1.1) = $909.09 paid today
(where 1.1 is 1 + interest rate expressed in decimals). In this
second example, $90.91 in "implied interest" gets you back to $1,000 a
year from now
The present value of future payments is used throughout finance,
including pricing of stocks and other securities:
QuickMBA
"Terminal Value"
http://www.quickmba.com/finance/terminal-value/
If any part of this answer is unclear, please let us know before
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"bond valuation"
Best regards,
Omnivorous-GA |
