十十 Asset Valuation: Debt Investments: Analysis and Valuation
1.A: Introduction to the Valuation of Fixed Income Securities
a: Describe the fundamental principles of bond valuation.
Bond investors are basically entitled to two distinct types of cash flows: 1) the periodic receipt
of coupon income over the life of the bond, and 2) the recovery of principal (par value) at the
end of the bond's life. Thus, in valuing a bond, you're dealing with an annuity of coupon
payments, plus a large single cash flow, as represented by the recovery of principal at
maturity, or when the bond is retired. These cash flows, along with the required rate of return
on the investment, are then used in a present value based bond model to find the dollar price
of a bond.
b: Explain the three steps in the valuation process.
The value of any financial asset can be determined as the sum of the asset’s discounted cash
flows. There are three steps:
Estimate the cash flows.
Determine the appropriate discount rate.
Calculate the sum of present values of the estimated cash flows.
c: Explain what is meant by a bond's cash flow.
This LOS is very straightforward. A bond's cash flow is the coupon or principal value. For an
option-free bond (meaning that the bond is not callable, putable, convertible, etc.), the
expected cash flow structure is shown on the time line below.
Where m = maturity, par, or face value (usually $1,000,
1,000, et cetera), CPN = (maturity
value * stated coupon rate)/# coupons per year, and N= # of years to maturity * # coupons per
year. So, for an arbitrary discount rate i, the bond’s value is:
.. + CPN
(l + i/m)
(1 + i/m)
(l + i/m)
Where: i = interest rate
(yield to maturity or YTM), m = number of coupons per
year, and n = number of years to maturity.
d: Discuss the diffulties of estimating the expected cash flows for some types of bonds and