How is the price of a bond calculated?

The price of a bond is determined by summing the present values of all future cash flows associated with that bond. These cash flows typically include periodic coupon payments and the face value that is repaid to bondholders at maturity. Each of these cash flows is discounted back to the present using the bond's yield to maturity or an appropriate discount rate, which reflects the time value of money.

Calculating the price this way captures the time-dependent nature of cash flows, recognizing that money received in the future is worth less than money in hand today. This process results in a comprehensive valuation of the bond based on all expected returns. By focusing on the present value of these cash flows collectively, the calculation provides an accurate representation of what an investor would pay for the bond today, reflecting both its income potential and the risk associated with the investment.

This method is critical for investors who need to evaluate whether a bond is priced attractively relative to its expected returns and the prevailing interest rates in the market.