About Fixed Income Instruments Training

Bond valuation and analysis is a strategy or process which is often used by the government or companies to determine the correct market value of the instrument. The valuation process factors in the current value of interest payment connected with the bond, and also the full value at the time of maturity, which is also known as the face value. Determining the fair value of a bond helps investors to find out the final return from investment and also whether it’s worth the money and time required for acquiring the bond and keep holding on to it until the time of maturity. Bond valuation may be done at home, but most investors choose to hire financial advisors for the purpose, because of their expertise and knowledge of the financial markets. But whether you do it on your own, or hire a financial expert, it’s necessary to know the basic information about the bond. This includes the amount and dates of interest payment, discount rates for payment, maturity date, and the par value of the bond at maturity.

Bonds of most companies state that the issuer i.e. seller or borrower of the instrument agrees to pay the investor i.e. the buyer or lender, fixed interest at regular intervals, besides a lump sum at the time of maturity. The amount of interest payable is determined by multiplying the coupon rate times with the par value of the bond.

A very important use of discounting

The current value of a bond is the sum of all future cash flows that could be derived out of it. In this sense, valuation of the instrument really becomes simple, and we like to believe it that way. All we have to do is to find the future stream of payment due on the bond, and then calculate the present value. In this way, we can find the proper valuation of the bond. While it may sound simple in the theoretical sense, in practical life, estimating parameters like discount rates that are an important factor in the calculation could be quite difficult. Besides, different discount rates could lead to conflicting valuations. Bond valuation, to an extent, is actually a game to guess what the future rate of discount will be.

The two components

Calculation of a bond’s present value is done by two components. These are as follows.

Annuity: A bond has a series of coupon payments due. These are commonly known as interest payments that are made periodically. Interests are usually paid every six months. In fact, companies all over the world pay interests twice every year because that’s a convention of the bond market. At the same time, it has to be understood that all bonds may have two values. The face value is the price at which the bond was issued, whereas the market value is the current price. If interest payments from a bond are not given directly, we have to compute them. The face value of the instrument is used in this regard. Remember, interest payments are calculated using the face value, not the market value. The annual rate of interest, as a result, should be converted to a six-monthly rate or any other appropriate rate, for paying investors. Then, it has to be incorporated into the formula to calculate the annuity, along with other details, for arriving at the current value of coupon payments pending.

Lump sum: Bonds pay interests all through their lifetime. But the principal is paid back only at the end of the lifetime. The principal, thus, is a lump sum payment which may need to be discounted several years into the future. Though this payment is not received twice every year, you have to still a factor in the six-monthly rate of interest to determine the present value of lump sum payment.

The final step involves adding the annuity’s present value as well as that of the lump sum. Both principal and the interest payments are thus added to arrive at the current value. The fair value of the instrument is thus derived.

Now let’s take a theoretical look at bond valuation. Here’s how the calculation is usually done.

The process

As already said, the bond valuation process factors in interest payments i.e. cash flow, connected to the bond issue. The cash flow, typically, is realised from interest payments. Interests are paid to the holders at fixed intervals, which in turn are related to the bond’s par value or face value at the time of maturity. By considering the overall value of investment from these two angles, it’s easier for investors to determine the fair value of the instrument, and whether it’s worth their time and money. If not, another investment could be chosen.

There are several complex calculations used to arrive at the fair of a bond. The face value of the instrument is usually determined by the relative pricing approach, which compares the bond to another standard bond, often a government one. A bond’s credit rating with comparable cash flows and maturity dates could be used for determining its fair value. Arbitrage-free pricing means subtracting all cash flow payments separately. The amount is arrived at by the rate of a zero-coupon based bond, on the day on which the interest is paid.

The stochastic calculus approach, another popular option, considers possibilities of variable interest rates. It deploys a partial differential mathematical equation for determining the fair market value of the instrument.

Variable interest

Valuing a bond could often be complicated if the interest rate connected to the investment is variable and not fixed. In such circumstances, you have to predict movements in the market and how they would impact the interest rate. Factoring those predictions to the performance of the bond can provide an informed idea regarding the amount of interest the bond will earn during its entire lifetime and the disbursement to investors. A number of investors try to figure out the worst possible scenario when the interest rate is variable or floating. They then take decisions depending upon the lowest amount of expected return after purchasing the instrument.

Factors to consider

Bond valuation plays a key role in an investor’s decision whether to purchase the instrument or not. But there are several other factors that must be considered. All bond subscribers know that such instruments carry a much lower risk or volatility compared to other investments. Even then, an investor needs to look carefully at the company’s financial stability before taking an investment decision. Even when the fixed interest connected to a bond looks attractive, buyers may not subscribe to it if the government or the company issuing it, is considered to be risky. Yet others may prefer to first study the past and present market trends on interest rates to determine if the value of the bond would decrease or increase with time.

Fixed Income Instruments Course Description

The bond valuation training course is as follows.

Introduction to fixed income instrument: You are introduced to fixed income instruments in this section. Subjects include bond market and instruments, treasury yields, studying the relation between yield and price, how to value treasury bonds, and pricing of bonds.

Understanding instruments and yield: This section is divided into five parts. Topics covered include zero coupon treasury bills and their valuation, understanding the spot rate, and zero coupon bond pricing.

Duration and convexity: Concepts of duration and convexity are covered in this section in two parts.