Financial Bonds

Bonds pay a fixed coupon (interest) at a fixed interval (usually every six months) and pay the par value at maturity.

Terminology:

• Bond: Fixed income securities; a debt contract promising a stream of known future cash payments to holders till the maturity date
• Bond indenture: All terms are specified in the contract: repayment type, issuer, maturity, collateral, etc.
• Maturity date: Final repayment date – payments continue until this date
• Term: The term remaining until the repayment date
• Principal or Face/Par Value: Maturity value/principal – notional amount used to compute coupon payments
• Coupon rate: A percentage of par value, expressed as an APR. This is fixed at issuance, and determines the amount of each coupon payment.
• Coupon payment: Promised interest payments, defined as $$\begin{array}{r}\\ \text{CPN}=\frac{\text{Coupon Rate}\times \text{Face Value}}{\text{Number of Coupon Payments per Year}}\end{array}$$

Bond Valuation

Following the valuation principle, the value of a bond is the PV of its expected future cash flows. Thus, the calculate the value of a bond, we need to:

1. Identify the size and timing of cash flows
2. Discount them at the correct discount rate, which depends on the default risk of the bond