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What is Definition, Formula & Types of Bond Pricing?
What is the Bond Pricing System?
Bond pricing is a measurement system that helps traders and financial enthusiasts keep track of bond prices before trading bonds with other investors. The price that one has to pay while purchasing the bond is the price of the bond and it is dependent on several factors like
The following are some of these characteristics −
The existence of a coupon, or the absence of one
Value of the main and par
Return on investment (ROI)
Periods of development till maturity
Bond Pricing − What factors impact it?
Coupons
$$\frac{1-(1+r/n)^{-n*t}}{r/n}+\frac{F}{{1+(1+r/n)^{-n*t}}}$$
Formula to calculate coupon bond price.
Some bands come with the coupons while others do not have an attached coupon, which adds to the nominal percentage of the principal amount of bonds. All coupons are tradable in a particular time frame and can carry specific amount. For example, there could be 5% coupon on a $500 bond that is redeemable.
The bonds that appear without a coupon are generally known as zero-coupon bonds and are priced lower than the ones that come along with coupon.
Zero-coupon bond price can be calculated using the below formula.
$$\frac{F}{{1+(1+r/n)^{-n*t}}}$$
Zero-coupon bond price formula.
Bond pricing is based on principal to par value.
Bonds must be issued with a par value that will be reimbursed when the bond matures. A bond would be worthless if the main value were not there. The main sum owed to the bond purchaser is due to be returned to the lender by the bond issuer.
The zero-coupon bond does not pay interest, but it does guarantee the return of the principal at maturity. Because the bond is offered at a discount to its par value, purchasers of zero-coupon bonds receive interest on their investment.
Yield to Maturity impacts Bond Pricing
Bonds are priced in such a way that they provide a particular rate of return to investors and often are sold at a premium when their rate of return upon maturity is lower than coupon price.
The connecting factor between this relationship between the yield to maturity and coupon rate could be changed in some very uncommon situations. When higher than market price premiums are made to bondholder, then the person has to pay premium for the variation.
The concept of the time value of money
The time value of money is an important tool used to determine the price of bonds. Based on the yield to maturity, every expense is discounted to the present period.
Creditworthiness of the organization
Bonds are assessed according to the creditworthiness of the company that issued them. There are five different ratings, ranging from AAA to D-plus. Bonds with ratings greater than A are often referred to as investment-grade bonds, whilst anything with a rating lower than A is referred to as trash bonds.
Payment Date Estimation
Lastly, the amount of time before the next coupon payment has an impact on the "real" price of a bond. 'Dirty' pricing is a more complicated bond pricing theory that is used in this case. It takes into consideration the interest that accrues between coupon payments when calculating dirty pricing. Bondholders will have to wait less time before getting their next payment as the instalments move closer together. Prices rise slowly as a result of this, before dropping immediately after the payment of the coupon.
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