Bond pricing is determined by discounting the present values of future cash flows generated by the bond. According to Alessandri and Nelson (2015), it is the total of the present values of all interest payments and the current value at maturity. Bond price is calculated by discounting the known future cash flows. Bond characteristics include; maturity, per value, issuer, and interest rate. Maturity is the date at which the bond matures where issuer pays the bond in full. Per value or face value is the amount the bondholder receives at maturity and the value at which the bond is issued for when the issuer makes a sale ( Alessandri & Nelson, 2015) . The issue is the borrower or debtor of the loan. The interest or coupon is the extra amount paid together with the principal amount.
The three factors that affect bond price are inflation, credit ratings, and interest rates. When the inflation is high the bond price decreases and when inflation goes down bond price increases. The inflation takes the purchasing power of what you earn on the investment. A credit rating provides information about the credit worth of debtor's ability to pay the interest payments and the principal amount.
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Yield calculation and prices of various types of bonds
The yields quoted for a bond can be calculated by yields to maturity, yield to call, current yields and yields to worst methods. It is calculated by taking annual return based on all interest payments plus the face value or market price. As Alessandri and Nelson (2015) explained, it is also considered as annual interest plus annual amortization divided by half the total market price and per value. Yield to call is the amount the investor receives if the bond is called before maturity. It is calculated the same way as yields to maturity; however one has to substitute call price with par value. The current yield is the rate of annual return on security. It is determined by taking interest earned annually then dividing by market price. Yield to worst is calculated by solving yield to maturity and yields to call.
Yield Curve
The yield curve is a line that plots interest rates showing several yields along a curve in different lengths at different maturity dates. The graph plots yields of similar quality bonds against maturity dates from the shortest to the longest.
References
Alessandri, P., & Nelson, B. D. (2015). Simple banking: profitability and the yield curve. Journal of Money, Credit and Banking , 47 (1), 143-175.
