Page 49 - Banking Finance November 2025

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A R T IC L E
when interest rates drop, allowing them to issue new
bonds at a lower rate.
Putable Bonds: These bonds give the investor the right
to sell the bond back to the issuer at a predetermined
price before maturity. Investors might exercise this
option if interest rates rise, enabling them to reinvest
at higher rates.
Example: An investor holds a putable bond but decides
to sell it back to the issuer when market interest
rates increase, thus avoiding losses due to falling bond
prices.

Valuation of Bonds
Calculate the Total Bond Value:
Bond valuation is a critical aspect of bond investing. The
Bond Value= PV of Coupons + PV of Face Value = 239.56 +
value of a bond is determined by the present value of its
680.58 = Rs. 920.14
future cash flows, which include both interest payments and
the principal repayment at maturity. Build-Up Approach for Bond Valuation

The build-up approach is a method used to estimate the
Present Value Formula required rate of return on a bond by adding various risk
premiums to the risk-free rate. The components typically
include:
1. Risk-Free Rate: The return on government bonds (G-
Let us assume the following. Secs) is often used as the risk-free rate.
C = Annual coupon payment (Rs. 60)
2. Inflation Premium: Compensates investors for the loss
r = Market interest rate or discount rate (8% or 0.08) of purchasing power due to inflation.
n = Number of years to maturity (5 years) 3. Credit Risk Premium: Reflects the issuer's

F = Face value (Rs. 1,000) creditworthiness. Higher-risk issuers must offer a higher
premium.
Step-by-Step Calculation: 4. Liquidity Premium: Accounts for the ease of trading the

1. Calculate the Present Value of Coupon Payments: The bond. Less liquid bonds carry a higher premium.
bond pays Rs. 60 per year for 5 years. The present value
5. Maturity Premium: Longer-term bonds generally have
of these coupon payments is calculated by discounting higher returns to compensate for greater risk.
each payment.
Example: If the risk-free rate is 4%, the inflation premium is
2%, the credit risk premium is 3%, and the liquidity premium
is 1%, the required rate of return would be 10%.

Trading of Bonds

Calculate the Present Value of the Face Value: The bond's Bonds can be traded in the secondary market, where prices
face value of Rs. 1,000 is paid at the end of 5 years, and its fluctuate based on supply and demand, interest rates, and
present value is: other economic factors.

Trading at Par, Premium, and Discount
At Par: A bond is said to be trading at par when its

44 | 2025 | NOVEMBER | BANKING FINANCE