Finance - Bond Pricing

Finance Discussion The market for bonds is not always liquid, but the same bond should buy/sell at the same price, if at the same time. If not, this will create an arbitrage opportunity and that arbitrage will align the prices on the different markets where the bond was priced differently. However, at different times, the price can change, based on the underlying factors that affect bond prices (Feldhutter, 2012). One such factor is time.

Each bond has a time value, which represents the present value of the future cash flows, and the risk that interest rates will change in that time. Thus, the same bond will see its price change, the closer it gets to maturity, even when the only thing that has changed is the time. Other changes will also affect bond prices. A change in interest rates will affect the opportunity cost of owning a given bond, leading to a change in its pricing.

If the risk of the underlying asset changes, that will also affect the price of the bond. So for example, if you buy a corporate bond, rated A, and this gets downgraded to BBB, then the price of the bond will change as a result of that. Bond prices are never set in stone, because of the risk of changes in the underlying factors affecting bond prices. 2. There is a market for bonds because investors sometimes prefer the security of fixed income.

Bonds provide certainty with respect to the amount of and timing of payments. There is a secondary market because sometimes people need to sell their bonds, and others are willing to buy them. Buyers of bonds will make adjustments to their bond portfolio -- adjusting the maturity and duration of the portfolio to suit their particular risk and cash flow needs.

Issuers of bonds do so for a variety of reasons, including the desire to retain control of their company and their desire to lower the cost of capital for their company (Diffen, 2015). Governments are major bond issuers, as this is the only way besides taxes and fees to raise capital. 3. Preferrred stock is sometimes treated as a type of bond, rather than equity for a couple of reasons.

The first is that preferred shares have a set dividend, which is paid out at a specific time, so the cash flows are similar to bonds (Morrison, 2012). Preferred shares are usually subordinated to debt in terms of payout, so they have a little bit more risk, but they are considered less risky than common shares. Furthermore, preferred shares typically do not have voting rights, unlike common shares, which typically do. This is another characteristic where a preferred share is more like a bond than equity.

Thus, preferred shares are sort of a hybrid of equity and bond characteristics, but for an investor, they are closer to a bond because of the fixed scheduled and amount of cash flows. 4. Bond prices are affected by the prevailing interest rates. The reason for this is that the bond prices reflect the net present value of the expected future cash flows from owning the bond. A change in the interest rate, therefore, reflects a change in the opportunity cost of owning a bond.

Thus, when the interest rate rises, the price of the bond declines, because the bond is less valuable today than it was yesterday, on account of what is essentially a higher discount rate. The inverse is also true --.