3.18.2005

Q: For bond valuations, what are the two...

...common apporaches? List some of their key differences.

A: The Discounted Cash Flow Valuation approach (DCF) calculates the present value of a financial asset by discounting its expected cash flows at an appropriate interest rate. DCF uses a single interest rate to discount all of a bond's cash flows, regardless of the timing of those cash flows. In reality, each individual cash flow is unique, thereby creating arbitrage opportunities.

The Arbitrage-Free Valuation approach values a bond as a package of cash flows, with each cash flow viewed as a zero-coupon bond and each cash flow discounted at its own unique discount rate. More specifally, V(0) = C/(1 + i(1)) + C/(1 + i(2))^2 + ... + (C + P)/(1 + i(N))^N. It effectively creates a synthetic coupon bond that has the same cash flows as the bond being valued.

Category: C++ Quant > Debt > Valuation

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