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What Is Matrix Pricing?
Matrix Pricing is a technique for estimating the price of bonds. This method helps ascertain the price based on the flat or quoted prices of similar, more frequently traded bonds with comparable maturity, coupon rates, and credit quality. This method is used when fixed-rate bonds are not actively traded on the stock market.
Matrix pricing is useful in situations where a bond’s market price is unavailable or does not exist. Hence, investors can calculate the rate of return through bond matrix pricing. Apart from price determination, it can also be used to determine market discount rates. The price estimation technique is also used to determine the price of fixed-rate bonds that have not been issued yet.
Table of contents
- Matrix pricing is a technique for estimating the price of bonds and their market discount rates. This method decides the price based on the flat or quoted prices of frequently traded bonds with similar maturity, coupon rates, and credit quality.
- Bond matrix pricing is helpful in situations where the market price is unavailable. Investors can calculate the rate of return using this pricing method by considering bonds with similar characteristics.
- This is done when fixed-rate bonds are not traded actively. The price estimation technique is also used to determine the price of fixed-rate bonds that have not been issued yet.
Matrix Pricing Explained
Matrix pricing is a method for estimating the price of a fixed-rate bond when it is not frequently traded or there is no market price. It employs market discount rates or prices based on quoted prices of bonds with similar features, such as coupon rates, credit quality, and maturity. The pricing method is used in two scenarios: when the bond is illiquid and when investors need to find the yield spread for bonds yet to be issued. In both situations, the market discount rate is calculated using bond yields or returns to maturity and by performing linear interpolation to compare similar bonds with credit ratings and risks.
The process of determining the price through this method is fairly simple. Bonds with comparable characteristics (such as issuer type, credit rating, coupon, term, etc.) are grouped as a single set to give the entire bond category a uniform yield level. The yield needed above the bond’s benchmark rate is typically estimated. The estimated yield level determines an approximate price for the specific bond within a category. The estimated price is not a real offer or trade price but an educated guess. Therefore, the method can also determine prices for bonds yet to be issued.
Types
Matrix pricing in the stock market differs from matrix pricing in marketing. Manipulating or adjusting the markup calculation to obtain the required gross profit percentage or margin is the idea governing the concept of matrix pricing. This principle applies to both stock markets and the marketing field. The matrix pricing types in marketing are flat pricing, straight line pricing, price averaging, family pricing, S curves, bell curves, etc. Bonds can be valued or priced in different ways, and matrix pricing is one method to do so.
Formula
The computation process derives value from a series of steps. The major component of the calculation is finding the yield-to-maturity figure. The formula to compute it is given below.
Yield-to-Maturity = /
Where,
- C represents the coupon rate.
- F represents the face value of the bond.
- P represents the current market price.
- n represents the years to maturity.
Examples
The following examples illustrate how matrix pricing works.
Example #1
Suppose Dave, an investor, is interested in estimating the price of a yet-to-be-issued bond. While interpreting what a matrix pricing procedure is, he felt that bond matrix pricing could be simplified using the following steps. These are:
- Step 1: In the first step, he tried to find comparable bonds with the same credit grade and determine their yield-to-maturity.
- Step 2: Then, he figured out the average yield for all similar bonds with the same maturity.
- Step 3: Here, he calculated the anticipated yield for the valued bond using linear interpolation.
Example #2
Let us take another hypothetical example. If investors want to analyze a bond with a 6-year maturity where the coupon rate is paid annually, they will need to analyze it using the matrix pricing method. Here, the bond to be issued is an AAA-rated bond. So the investor analyzed a few bonds valued at $100 but with the same rating and maturity. The yield-to-maturity is then calculated for the bonds, and the values are as follows:
| Bond | Maturity | Yield to maturity |
|---|---|---|
| A | 4 | 5.1 |
| B | 4 | 5.6 |
| C | 4 | 5.9 |
| D | 7 | 7.5 |
| E | 7 | 8 |
| F | 7 | 8 |
Yield-to-maturity of 4 years = 5.1%+5.6%+5.9%/3= 5.53%
Yield-to-maturity of 7 years= 7.5%+8%+8%/3=7.83%
With this, the value of the six-year market discount is estimated using linear interpolation:
Yield-to-maturity of 6 years = 5.53% + 6-4/7-4*(7.8%-5.5%) = 7% (approximately).
Through calculated moves, investors could predict that the yield-to-maturity of a 6-year bond lies between four years and seven years.
Frequently Asked Questions (FAQs)
A benchmark bond is a common yardstick by which other bonds' risks or returns can be compared. The same is applied in this pricing method, where standard prices are compared with other bond prices to arrive at a price estimate.
Matrix pricing helps investors ascertain the prices of stocks and securities trading on the stock market. It helps investors compute bond prices. Since stocks are frequently traded on the stock market, determining their price is relatively simple. Deriving the prices of bonds is challenging. Hence, the strategy is to compare similar/common parameters of various bonds to estimate the price of a similar bond.
It is the process of estimating the price of a bond by comparing debt issues and ranking according to the rating to rule out unwanted results. The debt-rating strategy is a less complex variation of matrix pricing.
The method of matrix pricing is often used to determine the pricing of fixed-income bonds that are not actively traded.
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