Price Of Any Financial Instrument Finance Essay - Free Essay Example

The price of any financial instrument is equal to the present value of the expected cash flows from the financial instrument (Fabozzi Mann, 2006, p. 121). In order to determine the price, it requires an estimate of the expected cash flows and required yield. Where the expected cash flows are refers to coupon payment and the required yield reflects the yield for financial instruments with comparable risk (Fabozzi, 2012, p. 16). The formula for pricing a bond: Where: P = bond price n = number of periods C = coupon payment r = periodic interest rate M = par value t = time period when the payment is to be received. The required yield is determined by investigating the yields offered on comparable bonds in the market (Fabozzi, 2012, p. 16). By comparable, it means option free bonds of the same credit quality and the same maturity. A fundamental of a bond is that the bond price changes in the opposite direction in the required yield (Mann Powers, 2002). It means that the required yield increases, the present value if the cash flow decrease and leads to price decrease. When coupon rate is equal to the required yield, the price of bond will be equal to par value. If the coupon rate is higher than required yield, the bond pr ice will be above par (sold at premium). However, if the required yield is greater than coupon rate, the bond price will be less than par value (sold at discount) (Mann Powers, 2002). As the bond move closer to maturity, most of the bonds will be priced equal to par value. Yield The yield on any investment, also known as internal rate of return is the interest rate that will make the present value of the cash flows from the investment equal to the cost of the investment (Fabozzi, 2012, p. 37). Mathematically, the yield (y) on any investment is the interest rate that satisfies the below equation. Where: CFt = cash flow in year t P = price of the investment N = number of years In order to solve the (y), it requires a trial and error method. The objective is to find the interest rate that will make the present value of the cash flows equal to the price (Fabozzi Mann, 2006, p. 121). It is the same formula to compute yield to maturity. There are several bond yield measures commonly quoted by dealers and used by portfolio managers. Current yield relates the annual coupon interest to the market price (Fabozzi Mann, 2006, p. 120). It takes into account only the coupon interest and no other source of return that will affect an investorà ¢ÃƒÆ' ¢Ã ƒ ¢Ã¢â€š ¬Ã… ¡Ãƒâ€šÃ‚ ¬ÃƒÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã… ¾Ãƒâ€šÃ‚ ¢s yield. Time value of money is ignored. Next, yield to call is assumes that issuer will call the bond at an assumed call data and the call price is the price that specified in the call schedule. The procedure for calculating the yield to any assumed call date is the same as any yield calculation: Where: M* = call price n* = number of periods until the assumed call date Yield to put is the interest rate that makes the present value of cash flows to be assumed put date plus the put price on the date as set forth in the put schedule equal to bond price (Fabozzi, 2012, p. 37). Lastly, yield to worst is the minimum of the yield to maturity, yield to call and yield to put. The procedure for calculating the yield to put is the same as any yield calculation: Where: M* = put price n* = number of periods until the assumed put date Arbitrage Opportunity in Bond Market Arbitrage refers to buying an instrument in one market and simultaneously selling it in another, gaining profit from the differences in buying and selling price (Fabozzi, 2012, p. 11). Arbitrage usually happens when the market is inefficient. The person who makes did this transaction by using the market inefficiency is called an arbitrager (Fabozzi, 2012, p. 11). In order to gain arbitrage in the bond market, once must buy a bond by borrowing from bank. During maturity, arbitrager will received the principal plus last coupon payment. Then use the amount received from the bond to repay back the bank. After repayment, the balance amount will be the arbitrage riskless profit (Choi, Getmansky Tookes, 2009). However, this rarely happens as demand of the bond increase will cause the bond price increases until the extent that there wonà ¢ÃƒÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã… ¡Ãƒâ€šÃ‚ ¬ÃƒÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã… ¾Ãƒâ€šÃ‚ ¢t be any arbitrage opportunity (Satya, n.d.). Choi, D., Getmansky, M., Tookes, H. ( 2009). Convertible bond arbitrage, liquidity externalities, and stock prices. Journal of Financial Economics, 91(2), 227-251. Fabozzi, F.J. (2012). Pricing of bonds. In bond markets, analysis and strategies 7th edition (p. 16). United States: Pearson Hall. Fabozzi, F.J. (2012). Pricing of bonds. In bond markets, analysis and strategies 7th edition (p. 37). United States: Pearson Hall. Fabozzi, F.J. (2012). Introduction. In bond markets, analysis and strategies 7th edition (p. 11). United States: Pearson Hall. Fabozzi, F.J., Mann, S.V. (2006). Bond pricing, yield measures, and total return. In the handbook of fixed income securities 7th edition (p. 107). United States: McGraw-Hill. Fabozzi, F.J., Mann, S.V. (2006). Bond pricing, yield measures, and total return. In the handbook of fixed income securities 7th edition (p. 120). United States: McGraw-Hill. Fabozzi, F.J., Mann, S.V. (2006). Bond pricing, yield measures, and total return. In the handbook of fixed inco me securities 7th edition (p. 121). United States: McGraw-Hill. Mann, S.V., Powers, E.A. (2002). Indexing a bondà ¢ÃƒÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã… ¡Ãƒâ€šÃ‚ ¬ÃƒÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã… ¾Ãƒâ€šÃ‚ ¢s call price: an analysis of make-whole call provision. Journal of Corporate Finance, 9(1), 535-554. Satya. (n.d.). Arbitrage opportunity in bond market. Retrieved March 10, 2013, from https://www.selfgrowth.com/articles/ArbitrageOpportunitiesInBondMarket.html