How Do You Price a Bond?
What a great topic to write about. How do you price a bond? I will first describe what you need to set a price on a bond and then I will show you how do you price a bond effectively. So, the answer to this big question, how do you price a bond?
I will assume you already know how bonds work. Our bond is a bond with yearly interests, which is the most common one. So what do you need to price a bond?
First you will need a nominal value of a bond. This is the money that you will get on the date that bons expires. We will assume that our bond has nominal value of 1.000 EUR.
Second thing you need to know is what percent do you get each year or with other words what is the size of cupons that this bond gives you each year. Let’s say that bond has 5 % interest rate per year, which means we get 50 EUR coupon each year.
Now demanded interest rates vary on the market in different times. This bond was released long time ago and the interest rate we want is now different than it was on the date of “give out”. So third we need a wanted return. Let’s say we want an 8 % return in one year.
We only need one more thing and this is the ammount of year until that bond will payour it’s nominal value. Let’s suppose that this bond has 10 years untill it’s payout. Now let’s set a price on our bond or with other words, let’s find out how much are we willing to pay for that bond today.
We just use a simple formula to set a price on our bond.
P=(C*((1/r)-(1/(r*(1+r)^n)))) + F/(1+r)^n
Now what are the symbols:
P… is the price we are willing to pay for our bond today
C… is the coupon per year, which is in our case 50 EUR
r… is the wanted retun, which is in our case 8% (remember to put in “numbers”, so use 0.08 in equation)
n… is the number of year untill payout
F… is the nominal value of bond or the value that will be given to us on the date of payout, which is in our case 1.000 EUR
Now all you have to do is put in the numbers and do the math. It’s very simple and you will see that if the wanted return (8% in our case) is smaller then given return (5% in our case), the bond will be on the market by a disscount price (smaller price than nominal value). While if the wanted return is smaller than given return (for example if we want 3% per year), we will be willing to pay more than a nominal price and the bond will be sold on a market in a premium price.
Hope I managed to explain to you how to price a bond. Good luck with your trade!
Written by: Matt
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