MGT411 Money & Banking Bond and Bond Pricing
A bond is a legal contract between two parties in which one party (the issuer or the borrower) promises to pay a series of payments to other party (the purchaser or lender )on a specific future date. The most common type of bond is coupon bond in which the issuer promises to make periodic interest payments in addition to the principal payment which is made at the maturity of the bond.
The price of a bond is the sum of present values of all the expected coupon payment plus the present value of the par value at maturity.
Present value of a coupon bond = present value of yearly coupon payments + present value of principal payment
Following formula is used for calculating the bond price:
PCb= [ Coupon payment + Coupon payment +… ...........+ Coupon payment ] + Face Value
(1+i)^1 (1+i)^2 (1+i)^n (1+i)^n
C = coupon payment
n = number of payments
i = interest rate
F = value at maturity, or par value
Lower the interest rate higher the bond price and vice versa.