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Many people know how to valuate the fair price of a stock but does not know how to valuate the fair price of a bond. Here is how it works & why I think it is useless to the individual:
The fair price of a bond (or equivalent the yield-to-maturity) of a bond is often made in comparison to the opportunity cost of investing in the bond. The opportunity cost measured is often the risk-free rate. Unlike the risk-free investment, a bond is not risk free and is subjected default risk. If there is no default, by definition both the par and the promised couples are paid to the investor. If there is a default, only part of those would be return. The fraction of the amount that can be return to the investor upon default of the bond is called the recovery rate.
Before I proceed, it is important to understand a probability theory called the total probability rule for expected value which states that:
E(A) = P(B) x E(A | B) + P( B') x E (A | B')
Where E(A) refers to the average value for a random variable A. “B” is an event and “B'” is a complementary event
Let R be the return of a bond and F be the risk free rate. The prudent investor would ensure that his average return of the bond is at least equal to the risk free rate otherwise he is better of investing in the risk-free rate. Thus, Read more...[caption id="attachment_1206" align="alignright" width="240" caption="Photo by Leonid Mamchenkov"][/caption]
Many people know how to valuate the fair price of a stock but does not know how to valuate the fair price of a bond. Here is how it works & why I think it is useless to the individual:
The fair price of a bond (or equivalent the yield-to-maturity) of a bond is often made in comparison to the opportunity cost of investing in the bond. The opportunity cost measured is often the risk-free rate. Unlike the risk-free investment, a bond is not risk free and is subjected default risk. If there is no default, by definition both the par and the promised couples are paid to the investor. If there is a default, only part of those would be return. The fraction of the amount that can be return to the investor upon default of the bond is called the recovery rate.
Before I proceed, it is important to understand a probability theory called the total probability rule for expected value which states that:
E(A) = P(B) x E(A | B) + P( B') x E (A | B')
Where E(A) refers to the average value for a random variable A. “B” is an event and “B'” is a complementary event
Let R be the return of a bond and F be the risk free rate. The prudent investor would ensure that his average return of the bond is at least equal to the risk free rate otherwise he is better of investing in the risk-free rate. Thus, Read more...
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Many people know how to valuate the fair price of a stock but does not know how to valuate the fair price of a bond. Here is how it works & why I think it is useless to the individual:
The fair price of a bond (or equivalent the yield-to-maturity) of a bond is often made in comparison to the opportunity cost of investing in the bond. The opportunity cost measured is often the risk-free rate. Unlike the risk-free investment, a bond is not risk free and is subjected default risk. If there is no default, by definition both the par and the promised couples are paid to the investor. If there is a default, only part of those would be return. The fraction of the amount that can be return to the investor upon default of the bond is called the recovery rate.
Before I proceed, it is important to understand a probability theory called the total probability rule for expected value which states that:
E(A) = P(B) x E(A | B) + P( B') x E (A | B')
Where E(A) refers to the average value for a random variable A. “B” is an event and “B'” is a complementary event
Let R be the return of a bond and F be the risk free rate. The prudent investor would ensure that his average return of the bond is at least equal to the risk free rate otherwise he is better of investing in the risk-free rate. Thus, Read more...
