This lesson examines the principles and techniques for valuing bonds and other fixed income instruments.

4.1 The Bond Pricing Equation

The value of a bond is the present value of its expected future cash flows: the periodic coupon payments and the repayment of principal at maturity. The fundamental formula for pricing a fixed-income instrument is provided in the ACT curriculum . Key concepts include:

  • Yield to Maturity (YTM): The total return expected on a bond if held to maturity . Yield to maturity (YTM) is the internal rate of return of a bond.

  • Bond Price and Yield Relationship: There is an inverse relationship between bond prices and yields. When interest rates rise, bond prices fall, and vice versa . Bond price and yield have an inverse relationship.

4.2 The Money Market and Debt Market

Treasurers must understand the difference between money market instruments (maturities of one year or less) and debt market (capital market) instruments, which have longer maturities . The money market deals with short-term debt; the debt market handles longer-term debt.

4.3 Risks Associated with Debt Instruments

Investing in fixed income securities involves several risks that must be understood and managed:

  • Interest Rate Risk: The risk that the value of a bond will decline due to rising interest rates .

  • Credit Risk: The risk that the issuer will default on its obligations .

  • Prepayment Risk: The risk that a bond will be repaid early, especially in a falling interest rate environment, reinvesting at a lower rate .

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