Deriving the bond pricing equation

Abstract

Given the recent focus on Eurozone debt crisis and the credit rating downgrade not only of US debt, but that of other countries and many UK major banking institutions, this paper aims to explain the concept of bond yield, its different measures and bond pricing equation. Yields on capital market instruments are rarely quoted on the same basis, which makes direct comparison between different as investment choices impossible. Some debt instruments are quoted on discount basis, whilst coupon-bearing ones accrue interest differently, offer different compounding opportunities, have different coupon payment frequencies, and manage non-business day maturity dates differently. Moreover, rules governing debt vary across countries, markets and currencies, making yield calculation and comparison a rather complex issue. Thus, some fundamental concepts applicable to debt instrument yield measurement, with focus on bond equation, are presented here. In addition, bond equation expressed in annuity form and used to apply Newton-Raphson algorithm to derive true bond yield is also shown.

Keywords

• bond yield
• bond equation
• true yield
• Newton-Raphson