A bond is a security that pays a stated amount of interest to the investor, period after period, until it is finally retired by the issuing company. Before we can fully understand the valuation of such a security, certain terms must be discussed. For one thing, a bond has a face value. This value is usually $1,000 per bond in the United States.

The bond almost always has a stated maturity, which is the time when the company is obligated to pay the bondholder the face value of the instrument. Finally, the coupon rate, or nominal annual rate of interest, is stated on the bond's face.2 If, for example, the coupon rate is 12 percent on a $l,000-face-value bond, the company pays the holder $120 each year until the bond matures.

In valuing a bond, or any security for that matter, we are primarily concerned with discounting, or capitalizing, the cash-flow stream that the security holder would receive over the life of the instrument. The terms of a bond establish a legally binding payment pattern at the time the bond is originally issued. This pattern consists of the payment of a stated amount of interest over a given number of years coupled with a final payment, when the bond matures, equal to the bond's face value.

The discount, or capitalization, rate applied to the cash-flow stream will differ among bonds depending on the risk structure of the bond issue. In general, however, this rate can be thought of as being composed of the risk-free rate plus a premium for risk.