How does bond pricing actually work? I keep hearing 'present value of cash flows' but need a concrete example.

Bond pricing is fundamentally about time value of money. You discount every future cash flow — each coupon payment and the final par repayment — back to today using the bond's yield to maturity (YTM) as the discount rate.

The Formula:

P = C/(1+r)^1 + C/(1+r)^2 + ... + C/(1+r)^n + FV/(1+r)^n

Where:

• P = Bond price
• C = Coupon payment per period
• r = YTM per period
• n = Number of periods to maturity
• FV = Face value (typically $1,000)

Worked Example:

Consider a 3-year annual-pay bond with a 6% coupon rate and a YTM of 5%. Face value is $1,000.

• Annual coupon = 6% x $1,000 = $60

The bond trades at a premium ($1,027.19 > $1,000) because the coupon rate (6%) exceeds the YTM (5%). Investors pay extra for the above-market coupon stream.

Key relationships to remember:

• Coupon rate > YTM --> Premium bond (price > par)
• Coupon rate < YTM --> Discount bond (price < par)
• Coupon rate = YTM --> Par bond (price = par)

For semiannual-pay bonds (the US standard), divide the coupon and YTM by 2, and double the number of periods. Practice this formula until it becomes second nature — it's tested heavily on the CFA Level I exam.

Explore our CFA Level I Fixed Income course for video walkthroughs of bond pricing problems.