Pricing a Bond

The fundamental principle of pricing a bond is that the price of a bond is the present value of all future cash flows that arise from the bond. As you know the money received today is more valuable than the same amount of money that will be received in the future at some point of time. So to know the current value of a bond we should discount the future cash flows from the bond with a proper discounting rate (also known as opportunity cost). This opportunity cost is usually the interest rate that is offered in the market on similar kind of bonds i.e. same tenor and same quality.

The general formula for calculating the present value of future cash flows is

PV = CF1/(1+r)^t1 + CF2/(1+r)^t2 + …….+ CFn/(1+r)^tn

In the above formula

PV is the present value of future cash flows CF1, CF2 etc are cash flow at nth period
r is discounting rate
t1,t2 etc are time intervals

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