The arbitrage free valuation approach is the process of valuing a fixed income instrument as a portfolio of zero coupon bonds. We can calculate the price of the bond by discounting each of the annual payments by the appropriate spot rate and finding the sum of the present values. Bond price = [60 / (1.05)] + [1,060 / (1.08)2] = $966. Or, in keeping with the notion that each cash flow is a separate bond, sum the following transactions on your financial calculator:
N = 1; I/Y = 5.0; PMT = 0; FV = 60; CPT → PV = 57.14
N = 2; I/Y = 8.0; PMT = 0; FV = 1,060; CPT → PV = 908.78
Price = 57.14 + 908.78 = $966.
