Bond Valuation definition, importance & relationship of market and fair-value

What does bond / debenture value mean?

Bond value is the fair (intrinsic / economic) value of the bond.

“Fair (intrinsic) value means the present value of all the future cash flows expected to be received or paid.” This is the amount an investor will be willing to pay keeping in mind the nature and riskiness of the future cash flows.

Another term MARKET VALUE of the bond is used. This means

“The value of bond determined by the market forces (financial markets since securities are traded in financial markets) where buyers and sellers determine the amount freely by mutual agreement and acceptance.” This is the actual price to be paid by the investor since he/she has to buy from the market.

If the fair (intrinsic) value of the bond is lower than the market value the bond is overvalued in investor’s point of view since he will purchase the bond form the market. On the other hand if fair (intrinsic) value of the bond is greater than the market value than bond is undervalue in investor’s point of view.

Why and to whom bond pricing is important?

The value of anything is determined when it is required to be sold or purchased. Same is true for bonds and debentures.

Like any commodity (e.g. car / table / edibles etc) purchased from the market, a buyer always want to know what price is offered for the commodity and whether this price is fair enough. In the same manner bonds and debentures are offered in financial markets for trade purposes. And rationale investors are always eager to know the price offered and the reasonableness of the price.

Therefore the investor is interested in the fair value and market value of the bond. Both these terms and their relationship is explained in below sections.

Relationship between bond’s market and fair value:

Market and fair value relationship is ruled by the concept of demand & supply of market.

The demand and supply concept says if a bond's fair value is more than its market value than investors will consider this bond highly profitable and make huge investments in the bond. Because of increased demand the price of bond in the market will go up and will reach a point where the fair value is below the market value. At this point investors will consider investment in the bond as a loss and will not buy the bond. The demand of bond will decrease, as a result, the price of the bond will also decrease and goes below its fair value and then again the whole cycle will repeat.

In practice, actually the bond’s fair value is equal to its intrinsic value due to efficient markets i.e. the markets where information is rapidly available and the market forces of demand and supply are efficiently playing their role. Thus these forces of markets do not allow the bond to be over or under valued.

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