1. What is a Bond
At the start of the last chapter, I explained that discounted cash flows
or DCF can be used to price financial assets such as stocks,
bonds, and even derivatives. In this chapter, you're going to look specifically
at using discounted cash flows to price bonds.
So what exactly is a bond? Well, a bond is a type of
financial security that allows an issuer, such as a company or a government,
to raise money from investors. The money raised must be repaid to investors
on a specified date called a "maturity date."
So bonds are a type of debt instrument.
If the issue date of the bond is January the 1st of 2024,
this would be a five year bond because it matures on the 31st of
December, 2028. The amount borrowed when a bond is first issued has several
names. This amount can be called the "face," "nominal," or "par"
value of the bond as the amount repaid by the issuer to the
owner of the bond on the maturity date.
Because the issuer of a bond is borrowing money from investors,
they usually pay interest to the investors, and the interest payment is
called a "coupon." The coupon rate is expressed as a percentage of par.
If the par value of a bond is 100, a bond paying an
annual 5% coupon means investors will receive a coupon of $5
once per year. The dates a bond pays a coupon to an investor is
called the "coupon date."
2. Let's practice!