Bonds are interesting when it comes to determining their value because of something called present fair value. Bonds are always worth a certain amount of money if they're cashed in. However, if you're seeking to sell them as-is, what are they truly worth since they also have an almost guaranteed rate of maturity?
Bond Fair Present Value
First, what is a bond? A bond is a kind of fixed-income instrument that individuals or organizations can purchase in the present with a guaranteed future value. It is technically a form of a loan because you're "loaning" the selling institution the present value by purchasing one. This loan comes with the promise that the financial institution will pay back a higher amount of money in the future, sometimes decades into the future.
As you might imagine, for a bond to be considered a good investment, the institution selling it must be very sound. That's typically why you hear about governments issuing bonds; investors can be fairly confident that the United States government will be around in the future. When the bond is issued, it includes terms that specify interest payments to be made and the maturity date. The maturity date is when the bondholder no longer collects interest; in other words, the bond will never be worth more than it is on the maturity date.
That being said, bonds can be sold, traded and bought again after their initial purchase by the lender, usually up to and past their maturity dates. To do that, you need to know the fair present value of the bond. Also sometimes called the bond valuation, this figure looks at the bond's eventual total value and then subtracts the interest rate yet to accumulate, explain the writers from Harvard Business School. That starts to get into the bond's fair interest rate, which is also an important concept for bond investors to grasp.
How to Calculate the Fair Value of a Bond
Using the bond coupon, determine the yearly value by multiplying the face value and the coupon rate. For example, if the bond's face value is $5,000 and the annual payout is 10 percent, the yearly value is $500.
Next, determine the discount rate. Add one to the coupon rate and then raise it to the power of the yearly payout rate as expressed in numerals (so 10 percent becomes 0.1). Divide one by the result and then subtract that from one. The result is the overall discount rate.
Next, take the overall discount rate and divide it by the current yearly rate. Then multiply by the cash flow amount. The number that you get is the current fair value of the bond.
Fair Interest Rate Formula for Bonds
Even if you're not involved in investing, the chances are good that you hear a lot about interest rates. Interest rates are among the most important determining factors when it comes to making investments. The SEC explains that these bond interest rates are called coupon rates. If you aren't comfortable making these determinations for yourself, you can consult a trusted financial advisor first.
Bonds have fixed interest rates, meaning that they will mature at a set rate regardless of how the market performs or the perceived value of the bonds. To calculate the fair interest rate of a bond, use the following formula. To do so, you'll need the bond's fair present value (FV bond), which is what it is worth currently. The formula for the fair interest rate of a bond is as follows: Fair interest rate = Coupon payment amount / FV of bond.
Consider also: Bond Stated Interest Rate Vs. Market Rate