Bond Pricing in the Market Contents

Points to Remember o The Primacy of Cash and Time o Risk and Return o The No-Arbitrage Principle o The Importance of Conventions Valuing a e!uence of Cash "lo#s o $etermining "uture Value o $etermining Present Value o $etermining %ield &ond Prices in the 'arket (hat )appens Around Coupon $ate Total Investment Return The *ast Coupon Period A econd ecurity Trading at a Premium Changing the $ay Count Convention Clean and $irty Prices o Trading o Accounting and Risk o Reporting 'ore on Net Present Value o $etermining the $iscount Rate o $etermining the Cash "lo#s + ,mbedded -ptions o Variable Rate ecurities o )andling Interest Rate ensitive "eatures pecial Topics o Additional %ield 'easures o $etermining %ield .iven Price o /uoted Prices o ,0ponential "ormulation Revie# /uestions o Income1,0pense Recognition o 'arketplace Redesign ,0ample &ond

Points to Remember
&efore getting into the details of bond pricing2 there are some background points that are useful to keep in mind3

The Primacy of Cash and Time

Investing is bottom-line oriented4 cash out vs3 cash in3 (hen you buy or sell a bond2 the cash is generally split among various categories3 "or instance2 #hen you sell a bond2 you normally receive cash for the accrued interest since the last coupon date 5see Trade Interest &ought1 old63 %ou may also pay a commission or fees3 &ut on a cash-flo# basis2 you only care ho# much you7re out of pocket3

Consumer Purchase Analogy

Consider the purchase of a consumer item on-line3 If t#o vendors charge the same price2 but one has t#ice the shipping charges plus higher handling charges than the other2 it7s not difficult to figure #hich is the better deal3 This may lead you to reconsider #hat the 8price8 really is3 %ou #ill probably also #ant to consider the vendors7 reputations 5user ratings6 #hen making your decision3 That7s #hy #e are being careful to talk about 8value82 not 8price8 or even 8market value8 5#e7ll get to these later63 (e are only concerned #ith ho# much you pay or receive3 Another aspect of this is that the relevant trade field for evaluating investments is always settlement date3 Thus interest bought1sold on a trade is based on settlement date rather than trade date3 *ike#ise interest income is al#ays figured on settlement date positions2 even though inventory and trading P9* are calculated on trade date positions 5for the reasons for using trade date for inventory2 see $ate &asis63

Risk and Return

Risk affects value3 In the Consumer Purchase Analogy2 the less trust#orthy vendor #ill not be able to get the same amount for the same goods3 'ore generally2 the higher the risk associated #ith a transaction2 the less you #ill be #illing to pay3 This is another #ay of saying you re!uire a higher return3

The No-Arbitrage Principle

This is a fancy name for 8you can7t get something for nothing83 Putting it more technically2 e!uivalent cash flo#s 5e3g32 coupon payments plus the return of principal6 #ith the e!uivalent risk must have the same value3 If t#o e!uivalent investments have different values2 you can make a risk-free return #ith no investment4 go short the higher value investment and long the lo#er value3 E ample The bond )I-VA* has a value of :;<3 The bond *--VA*2 #ith the same risk 5e3g32 the same issuer and terms6 and set of coupon and principal payments2 has a value of :;=3 To make your risk-free return2 #ith no investment on your part2 you sell the bond )IVA*2 receiving :;< in cash3 %ou buy *--VA*2 paying :;= from the :;< you received for the short sale3 %ou no# have :>2 #ith no investment on your o#n3 (hen you receive the coupon payments for the bond you o#n 5*--VA*62 you transfer the 5e!ual6 payments to the party you shorted )I-VA* to3 The same applies to the principal payment5s63 It is important not to forget the clause 8e!uivalent risk83 -ther#ise e!ual cash flo#s #on7t have the same value3 Conversely2 if e!ual cash flo#s have the same value2 they basically have the same risk3

The !mportance of Con"entions

*ike so much of the securities market and processing2 there are a number of conventions that you have to be a#are of and simply get used to3 It7s part of the process3 %ou may have a Ph$ in math2 but if you ignore the conventions you #ill be out of step #ith the market3 (hich means you #ill lose money as #ell as being confused3 (e #ill discuss the conventions as they come up3 These are some of the ones #e7ll address4

Price versus present value? principal and interest bought3 @nderstanding !uoted prices2 e3g32 8;<3A83 The rounding and significance of intermediate and final results3 %ield and 8'arket yield83 Clean and dirty pricing3 Coupon payments as 8simple83 Reinvestment assumption3

#aluing a $e%uence of Cash &lo's

The present value 5#e7re still not ready to talk about a 8price8 B see price in the .lossary6 of a se!uence of future cash flo#s is e!ual to the sum of the discounted values of those cash flo#s3 This is really Cust another #ay of stating the No-Arbitrage Principle3 If the present value #ere anything else2 you7d have a risk-free #ay to make money #ithout investing anything up front3

Rate( )ield( and Return

There are a number of related terms that address the time value of money3 The discussion here considers one4 ho# much is an investment #orth in one yearD If #e invest :EFF and receive :EFG in one year7s time2 our return is GH 5e0pressed decimally as F3FG63 (e #ill also call this yield3 If #e look at it the other #ay2 e3g32 #e are to be paid :EFG in a year and someone offers us :EFF no# for that payment2 #e say that it is being discounted at GH3 These are different #ays of saying the same thing2 and #e use the variable R to refer to it3 (e discuss other terminology in Additional %ield 'easures The problem2 of course2 is determining the appropriate discount rate to use3 "or our purposes2 #e take the rate set by the market3 After all2 that determines the cash you #ill have to invest3 If you think the market discount rate is too high 5and thus the amount to pay is lo#er than #hat you figure is appropriate62 then you #ill buy3 ince a higher discount rate is associated #ith greater risk2 another #ay of saying this is that you think the risk is less 5i3e32 usually that the issuer7s credit #orthiness is higher than #hat the market thinks63 If you think the issuer is more likely to default than the market thinks2 you #on7t buy3 It7s as simple as that3 &ut the rate is set by the market3 Valuing an investment basically looks at four factors4 cash in2 cash out2 time2 and risk3 (e are taking the discount rate as established by the market 5though #e #ill discuss it again briefly in $etermining the $iscount Rate62 leaving three factors3 There are a number of analyses of interest2 defined by the factor #e are solving for3

$etermining "uture Value3 This is for#ard-looking3 .iven a yield 5rate-of-return62 ho# much you #ill receive in2 say2 a year for a given amount investedD The

investment can be a bond2 C$2 bill2 bank account deposit2 or any fi0ed income instrument3 $etermining Present Value3 This is the opposite of the above2 determining the present value of a future receipt of cash at a certain time2 at a given yield3 $etermining %ield3 .iven a present value and future value at a specific time2 #hat is the yieldD

All three #ays are mathematically e!uivalent3 (e #ill discuss them in turn3

*etermining &uture #alue

E%uation $ummary
(e are concerned primarily #ith the follo#ing e!uations4 5I6"V5PV2 R2 T6 J PV K 5E L R6T 5M6PV5"V2 R2 T6 J "V15E L R6T 5A6PV5"Vs2 R2 T6 J Ni O"V5i615E L R6T5i6P 5=6R5PV2 "V2 T6 J 5"V1PV65E1T6 - E 5G6C%5CR2 "r6 J 5E L CR1"r6"r #here4 $ymbol Meaning CR Nominal 5stated6 coupon rate3 C% Annual coupon yield3 "r Coupon payment fre!uency3 "V "uture value3 PV Present value3 R Return2 on an annual basis3 T Time2 e0pressed in years3 If you invest :EFF2FFF in a security and get back :EFG2FFF in one year2 this is a GH annual return2 of course3 If you7d invested :>FF2FFF2 you #ould have received :>EM2FFF3 "or this reason2 the future value after one year is normally #ritten as4 "utureQvalue 5at one year6 J AmountQinvested K 5E L Rate6 If your :EFF2FFF investment has a constant GH return and you hold it for a second year2 ho# much #ill it be #orth at the end of the second yearD

The above formula still holds3 "or the second year the AmountQinvested is :EFG2FFF3 $oing the math you #ill have :EEM2M;F3FF at the end of the second year3 That it is not simply another :G2FFF reflects the compounding that is going on3 This can be #ritten more generally as 5E6"utureQvalue 5after NumQyears6 J AmountQinvested 5at TimeQF6 K 5E L Rate6NumQyears #here 8TimeQF8 refers to your initial investment3 The term of most general interest is the one on the right4 5>6"utureQvalueQofQ:E 5after NumQyears6 J 5E L Rate6NumQyears "or the value at the end of the second year2 NumQyears is > and 5E L Rate6NumQyears is 5E L F3FG6>2 or E3EMM;FF3 This e!uation applies to any value of NumQyears2 not Cust integers3 The same GH return for a half year is 5E L F3FG6F3A2 or E3FIMMF<3 "or one day #e have 5E L F3FG65E1I=A62 or E3FFFE<A3 The above e0ample highlights four amounts of interest4 $ymbol Meaning PV Present value3 In our e0ample this #as :EFF2FFF2 in 5>6 it #as :E3 "uture value3 After one year :E had a future value of :E3FGFF and after t#o years "V a value of :E3EMM;3 This is the return on an annual basis2 as described in the sidebar Rate2 %ield2 and Return3 R T Note that it is not the coupon rate3 (e haven7t reached coupons yet3 Time2 e0pressed in terms of years or fractions of a year3 "or simplicity #e take I=A days in every year3

Rno#ing any three of these values allo#s us to calculate the remaining one3 In the above #e solved for "V as a function of the others2 thus "V J "V5PV2 R2 T63 (e can re#rite e!3 E as 5I6"V5PV2 R2 T6 J PV K 5E L R6T

*etermining Present #alue

The bond pricing problem is different3 (e are given a set of future cash flo#s 5multiple "Vs6 at specific times2 from the bond prospectus3 The market determines the discount rate3 (e #ant to determine the value as of today3

(e start by determining the present value of a single payment2 for e0ample a coupon payment 5"V6 to be received a certain number of days from no# 5giving us T63 The rate 5R6 comes from the market 5#e continue to assume GH63 (e simply re-arrange the terms of e!3 I to get4 5M6PV5"V2 R2 T6 J "V15E L R6T If #e are to receive :IA in ;F days2 #e #ould have4 PV5"V2 R2 T6 J :IA15E3FG65;F1I=A6 PV5"V2 R2 T6 J :IM3M> If you have more than one future cash flo#2 you simply add the present values of each 5"V5E6 is the first cash flo#2 "V5>6 the second2 etc364 5A6PV5"Vs2 R2 T6 J Ni O"V5i615E L R6T5i6P

*etermining )ield
(hat if #e have a present value and a future value 5at some given time in the future6D (e #ant to determine the implied interest rate 5more commonly called 8yield8 in this conte0t63 (e can again rearrange the terms of e!3 I4 5=6R5PV2 "V2 T6 J 5"V1PV65E1T6 - E "or instance if #e are being asked to pay :IM3M> in order to receive :IA in ;F days2 #hat is the yieldD @sing e!3 = #e obtain the e0pected GH3 In practice this is the most important2 as it enables you to compare different cash flo#s on a consistent basis3 And yield is #hat an investor is interested in4 am I getting more or less for #hat I investD "or instance2 if someone 5#ith the same risk profile2 of course6 offers to sell you an investment that returns :MF in EFE days and #ants to charge you :I;3I=2 is that a better or a #orse deal than the one aboveD %ou calculate the yield2 #hich is =H2 and decide the first deal is better3 Computationally2 the problem is determining the yield of a series of cash flo#s 5e!3 A63 @nfortunately there is no closed-form solution 5i3e32 something like e!3 =63 The only #ay to solve the problem is by a series of trials and errors2 converging on the yield3 ee $etermining %ield .iven Price belo#3 "ortunately for this discussion2 #e #ill take the rate determined by the market3

Bond Prices in the Market

No# that #e have the math out of the #ay2 it7s time to see ho# bonds are priced in practice and #hat this means3 "irst2 forget the math3 The present value of a bond is determined by people participating in the market3 If someone thinks that2 given the current price2 they #ill be able to get a greater return than they can from e!uivalent investements2 they #ill buy the bond3 -ther#ise they #on7t2 or2 if they o#n the bond2 they may sell it3

Coupon Amounts
Coupon payment amounts are determined on a simple interest basis3 In our e0ample2 the bond has a A3GFH coupon rate 5CR2 aka 8nominal coupon rate86 and pays t#ice a year 5"r63 ,ach coupon payment is for >3<AH of the par value3 Note that receiving >3<AH t#ice a year is not the same as receiving A3GFH at the end of the year3 @sing e!3 I2 the annual coupon yield is actually A3G<E>H3 'ore generally2 5G6C%5CR2 "r6 J 5E L CR1"r6"r To have an annual coupon yield of A3GFH2 the semiannual coupons #ould have to be >3<EFAH3 It is true that they #ill make use of the techni!ues #e discuss here for evaluating future cash flo#s3 )o#ever2 that is not enough2 because there is uncertainty and risk in every bond 5even Treasuries2 #hich have the least63 ee 'ore on Net Present Value for a discussion of these factors3 The bottom line is that the present value is set by buyers and sellers in the market3 That is the starting point3 No# back to the math3 (e use the bond "-R$ A3GFFH >F San >FE>2 C@ IP IMAI;CTR<3 This bond has a A3GH nominal coupon rate 5CR6 and pays semi-annually2 every Sanuary and Suly >Fth3 It matures on >F San >FE>3 To obtain the full set of bond and trade parameters2 follo# the instructions belo# at O"-R$Q>FE>P3 (e start #ith the date < "eb >FF<3 The price is <F3F<G for settlement < "eb F<3 Note that though prices are normally !uoted on a trade date basis for normal settlement 5e3g32 TLE2 TLI62 everything on this page is settlement date basis3

The discount rate 5yield6 set by the market is E>3AG>H3 5(e note that the 8yield8 !uoted in the market reflects a market convention and is not the same as #hat #e #ill develop on this page3 ee 'arket %ield for a discussion and references36 *et7s see if #e can use e!3 A to verify the price3 %ou can easily program this analysis in a spreadsheet program3 There are < coupon dates after < "eb F<2 including the maturity date3 (e assume #e are purchasing :EFF2FFF in par value of the bonds3 ,ach semiannual coupon payment is :>2<AF3FF3 -n maturity date #e receive the :EFF2FFF par plus the final coupon payment of :>2<AF3FF3 5Throughout this e0ample #e ignore #eekends and holidays36 Present Value of O"-R$Q>FE>P Cash "lo#s >F San >F San >F San >F Sul F< >F Sul F; >F Sul EF >F Sul EE >F San E> F; EF EE Coupon >2<AF3FF >2<AF3FF >2<AF3FF >2<AF3FF >2<AF3FF >2<AF3FF >2<AF3FF >2<AF3FF Amt Principal EFF2FFF3FF "V 5total >2<AF3FF >2<AF3FF >2<AF3FF >2<AF3FF >2<AF3FF >2<AF3FF >2<AF3FF EF>2<AF3FF cash6 T 5in days6 T 5in years6 5E L R6T "V15E L R6T Notes4

E=I

IMG

A><

GE>

<;I

E2FGG

E2>A<

E2MM>

F3MM=AGA F3;AF=<M E3MM=AGA E3;AF=<M >3MM=AGA >3;AF=<M I3MM=AGA I3;AF=<M E3FAMIF< E3EE;E=M E3E<=<AA E3>A;<== E3II=F=G E3ME<>A= E3AFMFIG E3A;=AA; >2GFI3E; >2AM=3AM >2MFE3IF >2>=>3EM >2EII3EI >2FF;3AE E2<;M3;F =M2ME;3G=

8T 5in days68 is the actual number of days3 Again2 cash 5and time6 are king2 so day count conventions have not yet entered the analysis3 8T 5in years68 is done on a I=A day basis2 for simplicity3 The final ro#2 8"V15E L R6T8 is the discounted 5present6 value of the cash flo#3 The first coupon2 for instance2 has a present value on < "eb F< of :>2GFI3E;3 These are the terms on the right side of e!3 A3

As e0pected2 the present value of coupons farther out is less than that of those closer in3 The >F Sul F< coupon has a present value of :>2GFI3E;2 #hile the >F Sul EE coupon has a present value of :E2<;M3;F3

,!3 A has us add up the values in final ro# in the table3 Thus2

PV J :<F2IGF3MG This gives us a price of <F3IG for the :EFF2FFF par bond3 &ut the actual price for the trade is <F3F<G2 #hich is much lo#er than #hat #e calculated3 (hat7s going onD Interest bought1sold is #hat7s going on3 )ere7s ho# the market actually #orks4 The bond uses the IF@1I=F day count convention3 &et#een >F San F< 5the preceding coupon date6 and the settlement date 5< "eb F<6 there are E< days 5this convention uses IF days per month63 (ith E<F days in each coupon period 5a characteristic of this convention62 there is one-tenth of the >F Sul F< coupon payment included #ith the trade3 The coupon payment on :EFF2FFF on bonds is :>2<AF3FF3 Thus the trade includes :><A3FF in interest3 Remember that our present value is total cash3 ince there is :><A3FF in interest out of the :<F2IGF3MG present value2 that leaves :<F2F<A3MG for the rest of the trade2 #hich by definition is the principal3 This e!uates to a price of <F3F<A2 #hich is different from <F3F<G because #e are not using 'arket %ield in our calculations 5nor #ould #e #ant to63 Recapping2 this is the #ay bonds are priced in the market4 E3 The market determines the present value of the bond2 through the actions of buyers and sellers3 >3 $etermine the yield that2 #hen applied to the future cash flo#s2 results in the same present value3 Note that the yield is not used in the remaining steps3 I3 @se the applicable day count convention to determine the interest on the trade3 M3 ubtract the interest from the present value to get the amount termed the principal3 A3 $ivide by the par2 and you have the price3 It is not the case that the price is determined2 the principal is calculated2 and the interest is added in to get the net money3 The math #orks out to the same result2 and that is the #ay it is normally treated in IT and -ps2 but it is putting things back#ards from the point of vie# of the #ider conte0t3 5This can be seen in O' R&QRule.IIP 2 #here the formulas in ections 5b65i65&65E6 and 5b65i65&65>6 have the interest bought1sold as the last term on the right36 That7s really all there is to it3 "or the rest of this discussion #e e0plore the implications3

+hat ,appens Around Coupon *ate

The discussion above focused on a single day or a single #eek3 In this section #e look at #hat happens over longer periods2 and #hat happens over a coupon payment date3

The follo#ing table looks at t#o coupon payment dates2 >F Sul F< and >F San F;3 &oth payments are for :>2<AF3FF3 &esides the coupon date2 the day before and t#o days after are also sho#n3 The values are for trades settling on the given dates? these are not 8trade dates83 The top part of the table has the trade values2 and the bottom has the daily differences in these values3 Values around Coupon Payment $ates >F Sul F< and >F San F; 3 E; San >F San >E San E; Sul F< >F Sul F< >E Sul F< >> Sul F< 3 F; F; F; 3 Trade values Accrued interest Principal Net 'oney Price $aily $ifference s Accrued interest Principal Net 'oney Price

>> San F;

>2<IM3EG F3FF <E2<GI3A < <M2GFG3G A <E3<GI= <E2<<A3> M <E2<<A3> M <E3<<A>

EA3<I <E2<;A3; < <E2;EE3< E <E3<;=F

IE3=G <E2;F=3G > <E2;I<3I ; <E3;F=G

>2<IM3EG F3FF <M2F=F3E I <=2<;M3I F <M3F=FE <M2FG>3M ; <M2FG>3M ; <M3FG>A

EA3<I <M2F<I3; M <M2F;;3G G <M3F<I;

IE3=G <M2F;A3I ; <M2E>G3F = <M3F;AM

EA3<M EE3=M >G3M< F3FEEG

>2<IM3EG EE3== >2<>>3AE F3FEE=

EA3<I EF3GM >=3AG F3FEF<

EA3<M EF3GM >=3A< F3FEFG

EA3<M E>3IA ><3E; F3FE>I

>2<IM3EG E>3I= >2<>E3<E F3FE>M

EA3<I EE3MA >G3>< F3FEEM

EA3<M EE3MA >G3>; F3FEEA

(hat can #e learn from this data about #hat happens around coupon dateD These observations apply to bonds trading at a discount3 (e #ill discuss the premium case later3 #alue Net 'oney Comments Net money drops on coupon date because #e no# have one less future discounted cash flo#3 &ecause the coupon yield is less than the discount rate2 the drop is by less than the coupon amount3 This is another #ay of saying that the principal is belo# par 5i3e32 trading at a discount63 The general trend has to be up#ards in order to converge to par on maturity date3 Note ho# much higher the Net 'oney is on coupon date >F San F; than on >F Sul F<63 Thus2 though Net 'oney drops on coupon date2 the drop decreases as you get

#alue

Comments closer to maturity 5e3g32 the drop is less on >F San F; than on >F Sul F<3

Net money increases at an increasing rate #ithin a coupon period 5the e0ponential behavior of e!3 M63 %ou can see this in the period from >F Sul F< to E; San F;3 -ther than on the coupon dates themselves2 the increase in accrued interest is Accrued constant 5e0cept for rounding differences63 This is built into the day count Interest conventions3 &ecause the Net 'oney increase is al#ays higher then the increase in Accrued Principal Interest 5for this particular bond62 Principal #ill e0hibit a pattern similar to Net 'oney3 Price #ill mirror Principal2 of course3 'ost importantly2 splitting coupon interest out separately insures a more even price3 In our e0ample2 #here the market discount rate never changes2 #e see that the price increases very gradually and smoothly3 It is true that the increases changes Cust after coupon date 5because of the difference bet#een the coupon yield and the discount rate62 but it is much smoother than it #ould be if #e did not account for coupon interest separately3

Price

The value of the bond from the >F San >FF< to maturity on >F San >FE> is given in the figure belo#3 It assumes the market discount rate for the bond does not change3

The general up#ard trend is due to the fact that the bond is trading at a discount3 The upper sa#-tooth line is the net present value of the future cash flo#s3 The slope #ithin each coupon period corresponds to the market discount rate 5E>3AG>H63 The light area Cust belo# it is the accrued interest determined from the day count convention and coupon rate3 It is actually a fairly constant sa#tooth pattern 5see $ay Count Conventions63 The interest is going to#ards :>2<AF on >F San >FE>2 and the principal is converging to :EFF2FFF3 The principal is the lo#er portion of the figure and is by definition the difference bet#een the net present value and the accrued interest3 At this scale the fine structure given in the earlier table is difficult to pick up3 It is also true that many of the effects #e are discussing are !uite small in terms of the total present value2 and in the real #orld they can be s#amped by changes in the market interest rates and issuer evaluation3

Total !n"estment Return

&ut #hat7s happening to our original investment on coupon payment dateD )o# is it doingD Are #e actually losing money no#D

-n >F Sul F< #e receive the :>2<AF coupon payment3 Adding this to the present value 5i3e32 Net 'oney6 takes our total value to <M2GIA3>M3 This is an increase of :>G3M; over the prior day2 compared to an increase of :>G3M< on the prior day3 If you assume you can reinvest the coupon payment at the same return 5not coupon rate6 as the bond2 your total investment #ould sho# a smooth2 e0ponentially increasing curve3 This reinvestment assumption also comes into play #hen evaluating the initial investment decision3 (e invest :<F2IGF3MG at a yield of E>3AG>H2 maturing in E2MM> days3 (e might e0pect at maturity to have about4 "VJ :<F2IGF3MG K 5E L 3E>AG>6E2MM>1I=A "VJ :E><2IE=3>G &ut our total cash received is the sum of the < coupon payments and the principal4 CashJ < K :>2<AF3FF L :EFF2FFF3FF CashJ :E>>2<FF3FF The difference bet#een the calculated future value and the cash received is the reinvestment of the coupon payments3 If #e can 5and do6 reinvest them at a yield of E>3AG>H2 #e #ill end up #ith a total cash amount at maturity of :E><2IE=3>G3 -bviously there is risk in this assumption3 It is interesting that traders in investment firms do not get credit for the reinvestment income on cash generated3 A trader #ho held the security to maturity #ould be allocated :M>2M>;3AI in income2 not :MG2;MA3<F3 The trader #ould also be charged a money market rate of interest e0pense on the amount invested over the full holding period2 of course3

The -ast Coupon Period

There is generally no difference bet#een the final coupon period and the earlier ones 5the e0ception being a long or short final coupon period63 The accrued interest again goes to#ard :>2<AF2 #hile principal goes to#ards par4 :EFF2FFF3 &ond holders #ill receive :EF>2<AF on Sanuary >Fth3 Values in the *ast Coupon Period Trade values E; Sul EE >F Sul EE >E Sul EE >> Sul EE 3 EG San E> E< San E> E; San E> 3

3 Accrued interest Principal Net 'oney Price $aily $ifferences Accrued interest Principal Net 'oney Price >2<IM3EG F3FF EA3<I IE3=G >2<F>3AF >2<E<3II >2<IM3EG

;=2<GI3>E ;=2<<;3GI ;=2;FA3IM ;=2;>F3;A ;;2;MG3MM ;;2;=M3;A ;;2;<>3MG ;;2GFG3I< ;=2<<;3GI ;=2;>E3EG ;=2;A>3=> EF>2GM;3;M EF>2G<I3>< EF>2<E=3=M ;=3<GI> ;=3<<;G ;=3;FAI ;=3;>EF ;;3;MGM ;;3;=AF ;;3;<>A

EA3<M E=3AE I>3IA F3FE=A

->2<IM3EG EA3<I E=3A> EA3=E ->2<EG3=A IE3MM F3FE=A F3FEA=

EA3<M EA3=E IE3MA F3FEAG

EA3<I EG3AF II3II F3FEGA

EA3<I EG3AE II3IM F3FEG=

EA3<M EG3A> II3I= F3FEGA

A $econd $ecurity
(hat happens if "ord has also issued a discount security2 i3e32 one that has no periodic coupon payments2 only a final payment at maturity 5>F San >FE>2 the same as the bond6D (e #ill call this "ord-$ C3 It has all the other provision of the bond #e discussed earlier2 so it has the same risk profile3 (e buy :EF>2<AF par value of T%U-$ C on >F Sul >FEE 5settlement date62 the beginning of the final coupon period3 )o# much should #e e0pect to pay for itD .iven that it has the e0act same cash flo#s as the bond at that point2 and that they have the same risk profile2 the No-Arbitrage Principle tells us they have to have the same value3 o2 #e #ould pay :;=2<<;3GI 5see the table for The *ast Coupon Period63 This is also #hat #e #ould pay for the bond in total2 of course3 (hat happens to the end-of-day P9* accruals for the t#o securitiesD &ecause they #ill have the same total value the ne0t day2 #e #ould e0pect to have the same P9*3 And #e do2 but it looks a little different4 P9* Comparison O"-R$Q>FE>P "ord-$ C P9* Categories Interest Income @nrealiVed P9* RealiVed P9* Net Income EA3<I EA3=E F3FF IE3MM F3FF IE3MM F3FF IE3MM

If both securities are held to maturity2 they #ill both have :A2;=F3>G in income4 :EF>2<AF3FF - :;=2<<;3GI3 &ut the bond #ill sho# :>2<AF in interest income and :I2EEF3>G in realiVed P9*2 #hile the discount note #ill sho# it all in realiVed P9*3 .iven that cash is king2 #hat7s the Custification for the different treatmentsD (e invest the same amount up front and get the same amount out at the end of the period2 after all3 To confuse things further2 if there #ere other bonds in the final period but #ith different stated coupon rates2 #e could buy an amount of bonds that #ould return us :EF>2<AF at maturity3 (e #ould then have different splits bet#een interest income and trading P9* as #ell3 -n the off chance #e7re not confused enough2 couldn7t #e argue that #e should recogniVe our E>3AG>H annual return as interest2 #ith a straight return of the principal #e investedD That7s ho# a bank account #ould be handled2 #ith no realiVed P9* at all3 The short ans#er is that this is the convention3 This situation is #ell understood2 so #e all benefit from a common foundation3 Note that this situation e0ists only #hen #e are in a single payment period3

Trading at a Premium
The discussion above has been for a bond being discounted more than the coupon yield 5A3G<E>H63 This results in the generally increasing curve seen above3 The picture is some#hat different if the discount rate is belo# the coupon return3 If the market #ere discounting the bond at I3FFH2 the bond #ould be #orth more than par3 The bond converges to the same values on >F San >FE>2 but the path is different as sho#n belo#3

The net present value is still increasing at the discount rate 5I3FFH in this case63 &ecause the coupon yield is greater than this2 on coupon date the net present value drops by more than the amount of the coupon payment3 This results in the do#n#ard trend in the principal3

Changing the *ay Count Con"ention

(hat happens if the bond had a different convention2 say Act1Act 5IC'A6D This convention has the same coupon amounts as above2 but treats every day in a coupon period e!ually? no days are skipped3 There are E<> days bet#een >F San F< and >F Sul F<2 and E; days bet#een >F San F< and < "eb F<3 Thus2 Trade interest J 5E;1E<>6K:2><AF3FF Trade interest J :>;G3AI $oing the same math as before2 this results in principal on the trade of :<F2FG>3;M2 and a price of <F3FGI3 It may seem counter-intuitive that t#o bonds #ith the e0act same cash flo#s and risk profiles could have different prices3 &ut this Cust reinforces the fact that it is cash that is

king2 and that price is backed into3 If this #eren7t true2 you #ould have a risk-free arbitrage opportunity3 *ike#ise2 the t#o bonds may reflect different realiVed trading P9* for transactions involving the e0act same cash flo#s3 If the discount rate for the bonds doesn7t change2 and they are sold to settle one #eek later2 the present value of the cash flo#s goes up by :E<>3GM2 to :<F2AAI3>E3 This :E<>3GM is indeed our profit2 but ho# it is accounted for is different for the t#o day count conventions3 Changing the $ay Count Convention B P9* ,ffects Purchase $ale $ettlement $ettlement *ifference Classification.Comment < "eb F< EA "eb F< IF@1I=F Trade Interest Principal Net 'oney Price Act1Act 5IC'A6 Trade Interest Principal Net 'oney Price ><A3FF I;A3<I EEF3<I Interest Income GE3;E RealiVed P9* E<>3GM ame for both $CCs F3FGE;

<F2F<A3MG <F2EAG3I< <F2IGF3MG <F2AAI3>E <F3F<AA <F3EAGM

>;G3AI

MFG3EM

EF;3=E Interest Income GI3EI RealiVed P9* E<>3GM ame for both $CCs F3FGI> Reflects differences in principal2 and thus realiVed P9*

<F2FG>3;M <F2EM=3FG <F2IGF3MG <F2AAI3>E <F3FG>; <F3EM=E

.iven that the values of the t#o bonds are the same and the interest is different2 something else has to change3 The only possibilities are realiVed and unrealiVed P9*3 Thus it is generally not helpful to describe one day count convention as 8better8 than another2 or that one benefits the lender or the borro#er3 Sust because a IF1I=F bond may 8lose8 a day7s interest in Suly2 it does not mean that the market allo#s it to get lost in a total return sense3 This is one reason #hy fi0ed income investments are normally reported on an e!uivalent yield basis3

Clean and *irty Prices

-n >< "eb F< our bond 5O"-R$Q>FE>P6 has a value of :<F2IGF3MG3 (e then compute the interest based on the day count convention and back into a price for the remainder4 <F3F<AA3 .iven that #hat #e really care about is the money going out 5or coming in62 #hy not Cust skip the interest step and !uote a price of <F3IGFA in totalD tocks pay dividends2 and that7s the #ay they7re priced3 (e could go that route3 A trade done #ith interest figured separately is said to be done on a clean price basis3 The <F3F<AA above is the clean price3 A trade done for the total amount is said to be done on a dirty price basis3 <F3IGFA is the dirty price3 &oth trades #ill settle for the same amount3 -ne is not cheaper 5or more e0pensive6 than the other3 "or this e0ample #e have4 Clean vs3 $irty Pricing Clean *irty Principal <F2F<A3MG <F2IGF3MG Trade Interest ><A3FF F3FF Net 'oney <F2IGF3MG <F2IGF3MG Price <F3F<AA <F3IGFA

To a large e0tent this is a matter of follo#ing the market convention2 #hich is to use clean prices 5#e look at the reasons behind this convention in detail belo#63 Conventions do matter3 The price used also depends on the conte0t3 It is rare to use a dirty price on a trade or in accounting3 In various analytic applications2 ho#ever2 the dirty price is the norm3 'easures such as duration and conve0ity are al#ays done on a dirty price basis3 (e #ill return to these areas after discussing the reasons behind the clean price convention3 "inally2 8dirty8 is a value-neutral term3 It simply means interest is not broken out separately 5this is more accurate than saying the dirty price includes interest? interest as a separate component is an outcome of the clean price convention2 not anything inherent in the bond63 %ou could call it the 8full value8 price Cust as #ell3 8"ull price8 is sometimes used as another term for dirty price3

The Clean Price Con"ention

tocks 5often6 make periodic dividend payments2 Cust like bonds make periodic coupon payments3 tocks are traded 5and reported and analyVed6 on a dirty price basis3 (hy not bondsD

A better !uestion is2 #hy aren7t stocks traded on a clean price basisD The reason is2 they can7t3 Coupon payments are a contractual feature of a bond2 included in the prospectus3 The issuer does not have the right to suspend them3 The issuer may be forced to default2 for reasons of business survival2 but this is a dire step3 -n the other hand2 dividends are elective on the part of the issuer2 even for preferred stock3 The timing and amount 5if any6 is at the discretion of the issuer3 tocks are thus al#ays traded on a dirty price basis3 (ith bonds2 then2 #e have the choice of using clean or dirty prices3 (hy #ould #e #ant to use clean pricesD After all2 #e start #ith the dirty price and back into the clean price3 If the convention #as to use the dirty price2 there #ould be no need for day count conventions3 There are several very good reasons to prefer a clean price4

plitting out the interest bought1sold enables us to recogniVe the interest income as the bond is held 5this is the .AAP matching principle63 Thus #e also avoid the income spikes of the stock dividend model3 Interest bought1sold follo#s a fi0ed pattern period-to-period3 This means changes in value due to market conditions 5e3g32 changes in rate structures or issuer risk6 are isolated in the principal component of tne price3 As #e sa# in the graphs $iscount &ond and Premium &ond2 the full value of a bond drops sharply on coupon date3 plitting out the interest component results in the remainder of the bond value 5the principal2 by definition6 being much more closely aligned to the changes in the yield3 In our e0ample #e kept the yield fi0ed2 and the clean price is really !uite smooth3 The dirty price 5and associated principal6 #ould be very uneven2 reflecting the Cumps on coupon date3 tock dividends are usually for a smaller percentage than coupons2 so the drop is smaller3 tocks are also much more volatile3 If you look at the price history for a stock2 it is usually difficult to pick up the drop in price on e0-date3

&onds have less volatility than stock prices have3 tocks can drop or rise dramatically2 both long-term and short-term3 $ividends don7t account for as much of the fluctuation in the value of a stock that coupon payments do for a bond3 &y smoothing out the value of the principal2 realiVed and unrealiVed P9* are also smoother and more reflective of the underlying economic events3

The clean price approach thus leads to improvements in the !uality of the data on both the balance sheet and the income statement3 If you need to #ork #ith the dirty price2 you can al#ays create it from the clean price and interest bought1sold3

!mplications of the Clean Price Con"ention

The decision to use the clean price convention results in the follo#ing effects4

If you look to buy or sell a bond2 the price you are !uoted #ill be the clean price3 The #ord 8price8 al#ays means clean price3 The price printed on confirms is the clean price3 The price !uoted in the market2 and used for valuing positions2 risk analysis2 and compliance2 are al#ays the clean price3 The price printed on customer statements is al#ays the clean price3

.iven that the market adopted clean prices as the convention for trading2 dirty prices have to be used #ith caution3 (e look at the situation in a number of different areas3

Trading
In certain cases trades are done #ith a dirty price4 no separate interest bought1sold is incorporated into the trade figuration3 This is sometimes referred to as trading on a net money basis3 The trade settles for the full cash amount2 Cust as any other trade3 It is not true that any interest is 8lost8? the total value of the trade #ill not change3 The vast maCority of bond trades are figured on a clean price basis3 As long as both sides agree2 a trade can clear and settle 5see clearance63 )o#ever2 -ps is accustomed to handling trades on a clean price basis3 Anything that introduces nonstandard features increases both cost and the risk of operational error3

Accounting and Risk

$irty trades present a number of problems for the Trade Accounting and Risk functions3

)o# is the pending trade marked 5priced6 at end of dayD All !uoted prices are on a clean-price basis3 If the position is to be kept on a dirty price basis2 the interest #ould have to be figured and added to the !uoted clean price to get the price to use for marking3 A dirty-priced trade is one thing2 but a security position is another3 A given position #ill typically be impacted by many trades2 almost all of #hich are on a clean price basis3 )o# is the position 5as opposed to the trade6 markedD This includes not only the trade marking issue2 but the fact that the position may derive from a combination of dirty- and clean-priced trades3 This impacts accounting 5as #e sa# before62 compliance2 and risk3

Related to the marking issue is auditing3 Internal and e0ternal audit #ork on the basis of clean prices3

If you sell a clean-priced position on a dirty-price basis2 you #ill create unnecessary s#ings in interest income1e0pense and realiVed P9*3 The total #ill be unaffected2 but you are creating unnecessary confusion3

"or all these reasons2 in every instance #here #e have encountered a dirty-priced trade the firm has treated it on a clean price basis on its books and records3

Reporting
)ere the situation is more variable2 because of the number of different audiences and the different interests3 $irty-pricing can refer to reporting on both trades and positions3 "or the reasons given in the preceding discussion2 reports for accounting2 auditing2 risk2 and compliance are almost al#ays done on a clean-price basis3 The pricing choice affects P9*2 both interest and trading2 so you have to be consistent3 Reporting interest income1e0pense and trading P9* implies a clean-priced approach to principal 5and interest bought1sold6 as #ell3 If you are interested primarily in the value of your bond 5and this is of course a tremendously important issue62 you can certainly report it as the sum of the principal and accrued interest3 'any analyses are based on the full value of the investment2 so they use the dirty price approach3 ,0amples are duration and conve0ity3 The real issue is one of terminology3 In the industry 8price8 e0plicitly means the clean price3 imilarly2 the convention is that 8market value8 refers to !uantity times the 5clean6 price3 There are no standard terms for the dirty-priced values3 ometimes the market value based on principal alone is called the 8clean market value8 or the 8flat market value83 *ike#ise the combination of interest and principal 5at market price6 may be referred to as the 8full market value8 5and less fre!uently the 8dirty market value863 If you are in an area #here both full and flat market values are often reported2 the paramount consideration is to be e0plicit and consistent in ho# the values are labeled and referred to3

More on Net Present #alue

-nce you have the cash flo#s and the discount rate to apply2 calculating the net present value of a bond 5and2 kno#ing the applicable day count convention2 the accrued interest2 and then the price and principal6 is straightfor#ard3 This #as discussed above in Valuing a e!uence of Cash "lo#s3 Though not the focus of this page2 those 8givens8 re!uire a little further discussion3

*etermining the *iscount Rate

In our O"-R$Q>FE>P e0ample2 #e took the discount rate of E>3AG>H as a given3 (here did it come fromD The market2 certainly3 &ut ho# do #e decide if #e think this is the appropriate value to use2 and thus #hether the bond is a good investment or notD $etermining the discount rate is a huge topic2 so #e #ill only point out that it is based on a number of factors2 including4

'arket interest rates2 such as *I&-R or @ Treasuries3 The tenor of the bond3 The yield curve usually increases the longer until you are paid back3 If you invest in a *I&-R-based security #ith a si0-month maturity you #ill normally earn a higher rate than one maturing in one month3 A difficulty is that a bond typically has a se!uence of cash flo#s2 not Cust one at the end2 as #e have seen3 -ne approach is to #eight the cash flo#s by the period until they are received and use that as a measure3 This is one of the ideas behind the calculation of duration3

Credit #orthiness of the issuer3 %ou #ill demand a higher yield to compensate for the increased risk #ith a lo#er-rated issuer3 This is #hy Treasuries typically have the lo#est rates2 all else being e!ual3 "irms have credit analysts #hose e0plicit function is determining the credit #orthiness of bond issuers2 #hich factors directly into determination of the discount rate3

*etermining the Cash &lo's / Embedded 0ptions

$etermining the cash flo#s of a bond can be more difficult than determining the discount rate2 because it re!uires assumptions about future events3 ome of these events are features contained in the bond7s prospectus and typically include an element of choice3 These are called embedded options and are sometimes referred to collectively as a bond7s optionality3 Call Pro"isions -ur "ord bond 5O"-R$Q>FE>P6 has call provisions3 This enables "ord to buy back the bonds at certain times if they choose to3 Typically they #ill #ant to do this if interest rates fall to the e0tent that they can re-issue the bonds at a lo#er interest rate 5and thus lo#er cost to themselves63 -r2 less often2 they may be a#ash in cash3 This makes the calculation of net present value problematic2 as you no longer kno# the cash flo#s3 It certainly makes applying e!3 A difficult3 %ou do kno# up front that the call provision makes the investment riskier3 %ou can7t even do a buy-and-hold strategy counting on the stated coupon and principal payments3

This tells you that the bond must have a higher return than it #ould #ithout the call provision3 Amorti1ing $ecurities

Asset-Backed $ecurities
The holder of an asset 5basically a receivable in this usage6 often #ants to convert it into cash3 They can sell it directly2 of course2 but that is time-consuming and costly3 Another approach is to bundle a number of such assets and sell shares in the group3 The type of asset is very broad3 They can include4 'ortgages3 -utstanding credit card receivables3 Aircraft leases3 Auto loans3 The process of turning a group of related assets into a saleable security is called securitization3

Another source of uncertainty comes #ith amortiVing securities2 such as pools of mortgages2 #here the underlying mortgage holders have the option of paying off the principal faster than called for in the mortgage documents3 The future cash flo#s are even more variable and difficult to predict than #ith corporate bonds3 'ost asset-backed securities have such a feature3 'ortgage paydo#ns are also interest-rate sensitive2 of course3 If rates fall2 the person #ho took out the mortgage #ill be motivated to refinance2 i3e32 pay the e0isting mortgage off and obtain a ne# one at a lo#er rate3 If you hold such a security2 it also means that your reinvestment assumption #ill probably not hold3 &ut there may be other factors as #ell3 A community7s economic #ell-being can influence mortgage paydo#n rates3 Another complicating factor of these securities is that the underlying borro#er may default3 ,ach type of securitiVed asset has different repayment characteristics and various approaches to modeling them3 -ne of the more common is the P A prepayment model for mortgage-backed securities3 $inking &und Another embedded option is a sinking fund provision2 #here the issuer is re!uired to call a certain number of the outstanding bonds according to a fi0ed schedule3

Put 0ptions The bond holder may also have an option2 called a put option2 that enables the holder to receive payment of the outstanding principal from the issuer in advance of its stated maturity3 The holder may #ish to do so if interest rates rise or the issuer is deemed to be less credit-#orthy3 &eing in many #ays the opposite of a call option2 this feature reduces the risk to the bond holder2 #hich increase the value3

#ariable Rate $ecurities

Variable rate securities pose additional complications3 These bonds typically tie their coupon rates to a benchmark such as *I&-R or the IF-year Treasury3 This means that the coupon payments can change from period to period2 and they are not predictable3

,andling !nterest Rate $ensiti"e &eatures

'any of the features #e7ve been discussing in this section2 though not all2 are sensitive to future 5and unkno#n6 interest rate movements3 These movements impact both the discount rate 5R6 and the cash flo#s 5"Vs63 ome of the features2 such as the call and put options2 are binary in nature3 If the interest rate at the time #hen the embedded option can be e0ercised is belo# 5for a call6 or above 5for a put6 a given level2 the bond effectively matures at that point3 -ther features2 such as prepayments of principal on a mortgage-backed security2 are more involved3 If the interest rate comes do#n2 prepayments #ill go up3 This not only impacts the cash flo# at the time of prepayment2 but into the future as #ell3 The remaining interest payments #ill go do#n because of the reduced principal outstanding3 The future principal payments #ill also decrease2 of course3 Interest rates can vary over time2 so the prepayments must adCust on an on-going basis3 )o# can these features be handledD Closed form mathematical solutions are generally impossible for them3 A common approach is to devise a number of future interest rate scenarios and then model them2 advancing the time period-by-period and see #hat happens to the future cash flo#s 5e3g32 a lo#er rate may result in a bond being called63 ,ach scenario can result in a different present value3 The scenarios are assigned probabilities and the results combined3 -f course this leaves you #ith the problem of assigning priorities to each of the future interest rate scenarios3333

$pecial Topics

This section has a selection of sub-topics that amplify the material presented above3

Additional )ield Measures

In Valuing a e!uence of Cash "lo#s #e derived the basic formulas relating present and future values2 discount rate 5yield62 and time2 as summariVed in the ,!uation ummary3 This is #hat a mathematician #ould consider yield and is #hat you get if you use standard spreadsheet functions3 There are a number of other yield measures in use in the market2 and it7s helpful to be a#are of them3 The )ield Cur"e It is important to remember 5see the recap at the end of &ond Prices in the 'arket6 that the yield #e have been discussing #as backed into from the present value asssigned by the market3 It is an after-the-fact measure3 In particular2 this yield is applied uniformly to all future cash flo#s2 regardless of tenor3 &ut this is not the #ay the market actually operates3 "uture cash flo#s are valued based on the yield curve3 .enerally2 the yield is higher the longer the investment is held3 This means that in the ,!uation ummary the term R2 the discount rate2 should be a function of the tenor2 R J R5tenor63 8The yield curve8 itself is a bit of a misnomer3 ,very investment has an implicit yield curve3 The ones most !uoted are those based on Treasury instruments #ith various tenors and one based on *I&-R instruments3 Adapting these curves for use #ith an arbitrary investment is not straightfor#ard3

Not every possible future date has a data point on the 8curve82 so the intermediate dates must be interpolated3 &onds such as #e have been discussing #ill trade at a discount to Treasuries3 -ne approach is to adCust the Treasury curve up#ards until the present value calculated from the adCusted curve matches that established the market3 This assumes that the shape of the curve matches that of the Treasuries3 There is also the fact that the spread 5e3g32 E3AH6 over the Treasuries #ill usually change over time3

Market )ield The term 8yield8 in the bond market is defined slightly differently3 The market convention is based on coupon periods2 not straight time to the future cash flo#3 This is ho# trades are !uoted and is the value that #ill be printed on confirms3 This is the value #e sa# !uoted for the "ord bond3

The conventions can be found in O' R&QRule.IIP3 The formula in ection 5b65i65&65>6 corresponds to our e!3 M3 All bonds are assumed to have a coupon fre!uency of >2 #hich gives rise to the 8%1>8 terms3 The reliance on coupon periods is clear3 "urther2 there is are different function for securities in their final coupon period3 ection 5b65i65&65E6 has that formula3 Though different from our variable R2 the values are !uite close3 Note that this yield is sometimes referred to as the 8yield price83 $emiannual )ield The #eb page for O"-R$Q>FE>P has a value for 8 emiannual %ield8 of E>3>FF3 The 8Annual %ield8 is E>3AG>3 (e sa# this concept in Coupon Amounts3 @sing e!3 I2 :E3FF invested in this bond #ould have the follo#ing value in half a year4 "V J 5E L R6T "V J 5E L F3E>AG>6F3A "V J E3F=E (hat !uoted bond coupon rate corresponds to such a returnD Remembering that coupon payments are done on a simple interest basis2 #e simply double the F3F=E to get F3E>>2 or a coupon rate of E>3>FFH3 This is 8 emiannual %ield83

*etermining )ield 2i"en Price

In $etermining %ield #e noted that there is no closed form solution to the problem of determining yield if #e are given the present value and a series of future cash flo#s3 If you build a spreadsheet #ith the future cash flo#s2 you parameteriVe the present value function #ith a value for yield3 %ou sum up the present value of each cash flo#2 and that sum gives you the present value 5and thus the price6 for the entered yield3 If you #ere given the price and asked to find the yield2 ho#ever2 you #ould probably proceed by fiddling #ith the yield parameter until the price you calculate e!uals the one you #ere given3 In this #ay you7ve determined the yield3 This trial and error approach is #hat is used in practice3 The most common method encountered is Ne#ton7s 'ethod3 It is used because of its convergence characteristics3

To use Ne#ton7s 'ethod2 the 8Vero8 you are searching for is the e0pression 8priceQinQtheQmarket - priceQyouQcalculate83

3uoted Prices
If you buy a bond that #ill pay :E2FFF at maturity for a price of ;<3A2 you pay :;<A3FF in principal2 not :;<2AFF3 5If you buy E2FFF shares of stock at a price of ;<3A2 you #ould pay :;<2AFF36 This is simply the bond market convention3 It is sometimes referred to as 8the price per :EFF par value83

E ponential &ormulation
In Coupon Amounts #e sa# that receiving a semiannual coupon at half the nominal coupon rate 5CR6 results in a higher annual yield 5R64 5E L CR1>6> - E3 R continues to increase as #e increase the compounding fre!uency 5> in the e0ample6 and converges in the case of continuous compounding to4 E L RJ eCR 5continuous compounding6 and for a time T4 5E L R6TJ eCRKT 5continuous compounding6 People sometimes use eCRKT in place of the correct e!uation 5e!3 I62 5E L R6T2 #hen computing interest for a given annual return 5i3e32 there is no compounding involved63 If you #ant to take advantage of the e0ponential formulation and still be accurate you need to adCust the e0ponent3 (e use 8r8 to refer to the value #e7ll use in the e0ponential formula 58ln8 is the natural logarithm63 erJ 5E L CR1"r6"r rJ "rKln5E L CR1"r6 Then indeed erTJ 5E L R6T

Re"ie' 3uestions
The topics of bond pricing2 yield calculations2 coupon interest2 and day count conventions can be very challenging2 at least as much for the mechanics e0hibited in the market as for

the inherent comple0ity3 These Revie# /uestions have been developed to help you to think about the topics more broadly3 If you #ould like to discuss these Revie# /uestions2 please feel free to e-mail us at R/&ondPricingWeclipsesoft#are3biV3

!ncome.E pense Recognition

(e discussed under A econd ecurity some of the implications of the market convention that e!uates interest income #ith the amount of coupon interest earned3 Consider a coupon-bearing bond that #e are holding 5thus #e don7t have to consider realiVed P9* arising from a sale63 The value goes up 5or do#n6 as time passes2 the market discount rate fluctuates2 and cash is received3

)o# many categories of return 5i3e32 change in value in this scenario6 do you think should be trackedD (hat #ould they beD (ould you accord any special treatment to the stated coupon rateD (ould you accord any special treatment to changes in the market discount rate for the bondD (ould you differentiate bet#een changes in the overall market interest environment and changes applicable only to the applicable bondD (hat should be reflected after a coupon payment is receivedD

Marketplace Redesign
It is a natural reaction to these topics to feel that there must be a better #ay for the markets to operate3 The second Revie# /uestion is4

Redesign the #ay the market prices bonds2 including interest2 yield2 and optionality3 &e complete2 yet concise3

"or e0tra credit address the conversion of e0isting securities and market practices to your proposed redesign3

E ample Bond
O"-R$Q>FE>P To get the data for the bond #e treat on this page 5"-R$ A3GFFH >F San >FE>62 perform the follo#ing steps4 .o to Corporate 'arket At-A-.lance2 ,nter the C@ IP IMAI;CTR< under 8&ond )istory83 Press 8Continue83 Click the link under 8X -" TRA$, 8 on the right3 Click the 8I Agree8 bo0 and press 8Continue83

-n the screen 8Trade $etails for C@ IP4 IMAI;CTR<82 find the trade #ith trade date F>1FA1F< EM4M>4F>3 Click the 8run calculations8 link on the right3

This #ill give you all the data #e discuss on this page3 O"INRAQTRAC,P &onds do not trade on an e0change like the N% ,3 )o#ever2 trade information is reported to the O"INRAP 5formerly NA $6 TRAC, system3 This is the standard source of bond trade information and is the source of the ra# data for O"-R$Q>FE>P3 The trade analyVed here can also be found through the "INRA &ond earch3 )o#ever it does not give you !uite the same breadth of analytic data3 Coupon Interest

Contents

&uying and elling a &ond Interest "iguration Routines o Trade Interest &ought1 old o Interest Income and ,0pense -n Record $ate 'onth ,nd T#o /uestions $ay Count Conventions o $ecision4 Constant Interest Period o $ecision4 $etermining $aily Interest o $ecision4 IF1I=F $aily Interest plit o Remarks $ividend Comparison

-n this page #e address the handling of coupon interest on fi0ed income instruments3 It is a companion page to $ividends3 (e look at ho# a securities firm 5-urCo6 should address trades2 positions in firm and customer accounts2 fails2 and stock borro#1loan arrangements3 (e are interested in the accrual and cash accounting2 the receivable1payables 5if any62 and the actual cash movements3 (e start #ith T%U Corp3 It has issued bonds 5T%U-G3>6 that have a fi0ed G3>H interest rate and pay !uarterly on I1FE2 =1FE2 ;1FE2 and E>1FE3 )olders of record are determined on the last day of the preceding month3 The bonds use the IF@1I=F day count convention3 %ou are probably a#are that transactions in fi0ed income instruments typically include an interest bought1sold amount 5this is the reason the trial balance #ill be different from that

for dividends62 #hich leads into figuration routines and everything having to do #ith day count conventions and business day conventions3

Buying and $elling a Bond

In this section #e look in detail at buying and selling a bond and ho# income is recorded3 (ith dividends the income1e0pense is recogniVed and realiVed #ith the dividend itself3 The reason is that the dividends are elective on the part of the corporation declaring them 5even on preferred stock63 "or bonds2 ho#ever2 the payments are part of the contractual terms of the issue2 so income can be recogniVed during the period it is held2 even if no coupon is received during that period3 The coupon interest is 5basically6 distributed on a straight-line basis over the holding period bet#een payments 5see the figure IF@1I=F ingle Period63 If you buy a bond three days into a coupon period2 you #ill be buying three days7 #orth of interest3 This gives rise to the sa#-tooth figures you are probably familiar #ith 5e3g32 IF@1I=F 'ultiple Periods63 "or a good discussion see ORisk.lossaryP? it also addresses many of the topics covered here3 Also see O ecurities-psF>P2 p3 E>E3 Note that figuration of trade price and interest is on a settlement date basis3 (ith stocks the market price on a given date is for a trade that follo#s normal settlement 5e3g32 TLI63 The same applies to bonds 5though 8normal settlement8 may be a different number of days63 "urther2 the interest bought1sold is based on trade settlement date2 not trade date3 People sometimes get confused because trader inventory 5and realiVed and unrealiVed P9*6 is reported on a trade date basis2 #hile interest income1e0pense is calculated on the settlement date position3 -urCo7s trading strategy is to buy the T%U-G3> bonds on =1FI 5a 'onday62 hold them for t#o days2 and then sell them3

*ay 45 6.78 9Monday:

Account Codes
Code *escription &@A Interest income accrued at end-of-day on a long position3 The offset is to &@I3 &@I Interest bought on a &@% trade3 The offset is a customer payable3 &@P Principal on a &@% trade4 !uantity K price3 The offset is a customer payable3 Coupon clearing3 The &@I balance on long positions 5and ,I on shorts6 is cleared CPC out to CPC as part of coupon day processing3 The net CPC balance is then cleared out to a coupon receivable or payable2 depending on the net position3 C ) Cash in the bank3 ,A Interest e0pense accrued at end-of-day on a short position3

Code *escription ,I Interest sold on a ,** trade3 ,P Principal on a ,** trade4 !uantity K price3

T%U7s bonds trade on a TLI basis3 -n =1FI -urCo trader ;FE> buys :EF2FFF par of T%U-G3> bonds at a price of ;F from counterparty GIIM3 )o# much interest does trader ;FE> buyD The most recent record date #as A1IE3 There is no interest bought1sold on the payment date2 =1FE3 -n =1F> there7s one day7s interest2 and so on3 o2 trader ;FE> is buying A days7 interest 5remember that #e are using the settlement date2 =1F=2 not the trade date63 :EF2FFF par bonds have :> in interest per 8day8 5:EF2FFF K F3FG> 1 I=F63 To keep the math simple #e #ill assume that the bond trades at ;F the entire period #e are considering3 o2 -urCo #ill have to pay a total of :;2FEF4 :;2FFF in principal and :EF in interest3 -ur "rame#ork records the transaction as given in the follo#ing table3 5The model is introduced in $ata tructures? additional e0amples can be found in Transaction -perations36 The register information folds the distribution 5both money and !uantity6 onto several ro#s to save space3 The account codes &@P and &@I denote the long principal and interest bought and are described in 'oney Accounts3 &irm Buy of ;47(777 bonds <)=->?@ on 6.78( $ettlement on 6.76 Register ,ntries Aey Type $ecurity 3.M *istribution $ate4 =1FI >E>> E &@% T%U-G3> / EF2FFF T ;FE> C GIIM ' ;2FFF . &@P C GIIM ' EF . &@I C GIIM

Associations Aey Type A0 M A0 3

The positions and balances are updated as sho#n belo# 5#e assume the trader has no earlier activity in this security63 The trade date 5T,6 figures are first2 follo#ed by settlement date 5 ,63 Positions 5/6 and balances 5'6 are given for each date basis3 The first amount 5al#ays F in this e0ample6 is the beginning balance for the month2 the ne0t amount is day E2 etc3 =1F< and =1F; are a #eekend2 so #e abbreviate them #ith an ellipsis3 The values are the same as for =1FG3 imilarly2 all days after =1EF have the same values as on =1EF3 As discussed in Positions and &alances2 future periods are updated #hen transactions are entered3 This is a key component of Temporal Independence3

Positions 93: and Balances 9M: / as of 6.78 6.7 6.7 6.7 6.7 6.7 ?? 6.4 ?? 8 B C 6 > ? 7 ? T% T PRI ;F / T U, ' E> G3> T% T PRI GI / C U, ' IM G3> FFF EF2F EF2F EF2F EF2F EF2F 33 EF2F 33 FF FF FF FF FF 3 FF 3

33 33 FFF EF2F EF2F EF2F EF2F EF2F EF2F 3 3 FF FF FF FF FF FF

T% T PRI & ;F ;2FF ;2FF ;2FF ;2FF ;2FF 33 ;2FF 33 ' . UFFF , ' @P E> F F F F F 3 F 3 G3> T% T PRI & ;F 33 33 ' . UFFFEF EF EF EF EF EF , ' @I E> 3 3 G3> T% T PRI GI 33 33 ' C UFFF ;2FE ;2FE ;2FE ;2FE ;2FE ;2FE , ' IM 3 3 G3> F F F F F F T% PRI ;F T U, ' E> G3> T% PRI GI / C U, ' IM G3> / EF2F EF2F 33 EF2F 33 FF FF 3 FF 3 33 33 EF2F EF2F EF2F 3 3 FF FF FF ;2FF ;2FF 33 ;2FF 33 F F 3 F 3 EF EF 33 33 EF 3 3

FFFF FFFF

F F

F F

T% PRI & ;F ' . UFFFF , ' @P E> G3> T% PRI & ;F ' . UFFFF , ' @I E> G3> T% PRI GI ' C UFFFF , ' IM G3>

F F F

F F F

33 33 ;2FE ;2FE ;2FE 3 3 F F F

(hat happens at end-of-day on =1FID Nothing3 (e #on7t begin earning interest until #e have a settlement date position2 #hich occurs on =1F=3 Normally the price #ould be changing2 so #e #ould have unrealiVed P9*3 If there #ere other trading going on in the bond2 #e could also have realiVed P9*3

*ay @5 6.7B 9Tuesday:

Nothing happens3 (e assume the price is constant2 and #e don7t accrue interest as #e have no settlement date position3

*ay 85 6.7C 9+ednesday:

(e sell the bond2 again at par3 The counterparty is G=GA3 )o# much interest is there associated #ith the bondD &ecause the third calendar day out is a aturday2 settlement date #ill be =1EF3 This means there #ill be ; days7 interest2 or :E<3 Acti"ity through 6.7C Register ,ntries Aey Type $ecurity 3.M *istribution $ate4 =1FI >E>> E &@% T%U-G3> / EF2FFF T ;FE> C GIIM ' ;2FFF . &@P C GIIM ' EF . &@I C GIIM $ate4 =1FA >E>= E ,** T%U-G3> / EF2FFF C G=GA T ;FE> ' ;2FFF C G=GA . ,P ' E< C G=GA . ,I As discussed in Inventory and Trading P9*2 having separate principal accounts is e0tremely useful in the calculation of realiVed P9* because of the re!uirement to differentiate bet#een a &@% and a reversal of a ,** 5and vice versa63 This situation does not apply to interest? it acts as simply as unrealiVed P9* does3 (e sho# t#o accounts here simply for parallelism #ith inventory3 This does mean that &@I and ,I #ill also re!uire a housekeeping step to combine them in the database3 (e #ill al#ays present the positions and balances after that step has been performed3 &ecause #e still have no settled position 5the ,-/ ro#s for a trading account62 there #ill be no interest accrual3 Positions 93: and Balances 9M: / as of 6.7C 6.7 6.7 6.7 6.7 6.7 ?? 6.4 ?? 8 B C 6 > ? 7 ? FFFEF2F EF2F F F F 33 F 33

Associations Aey Type A0 M A0 3

T /PRI T;F T%

Positions 93: and Balances 9M: / as of 6.7C 6.7 6.7 6.7 6.7 6.7 ?? 6.4 ?? 8 B C 6 > ? 7 ? , ' E> UG3> T% UG3> T% UG3> FF FF 3 3

T PRI GI / C , ' IM T PRI G= / C , ' GA

33 33 FFF EF2F EF2F EF2F EF2F EF2F EF2F 3 3 FF FF FF FF FF FF FFFF F EF2F EF2F EF2F 33 EF2F 33 FF FF FF 3 FF 3

T% T PRI & ;F ' . U, ' @P E> G3> T% T PRI & ;F ' . U, ' @I E> G3> T% T PRI GI ' C U, ' IM G3> T% T PRI G= ' C U, ' GA G3> T% PRI ;F T U, ' E> G3> T% PRI GI / C U, ' IM G3> T% PRI G= / C U, ' GA G3> /

FFF

;2FF ;2FF F F F

F -<

F -<

33 F 3 33 -< 3

33 3 33 3

FFFEF EF -<

33 33 FFF ;2FE ;2FE ;2FE ;2FE ;2FE ;2FE 3 3 F F F F F F FFFF F ;2FE ;2FE ;2FE 33 ;2FE 33 < < < 3 < 3

FFFF FFFF FFFF

F F F

F F F

EF2F EF2F 33 F FF FF 3

33 3

33 33 EF2F EF2F EF2F 3 3 FF FF FF F F 33 EF2F 33 3 FF 3

T% PRI & ;F ' . UFFFF , ' @P E> G3> T% PRI & ;F ' . UFFFF , ' @I E> G3> 'PRI CGI T% FFFF , ' IM U-

F F F

F F F

;2FF ;2FF 33 F F F 3 EF EF 33 -< 3

33 3 33 3

33 33 ;2FE ;2FE 3 ;2FE 3

Positions 93: and Balances 9M: / as of 6.7C 6.7 6.7 6.7 6.7 6.7 ?? 6.4 ?? 8 B C 6 > ? 7 ? F F F FFFF F F F F 33 ;2FE 33 3 < 3

G3> T% PRI G= ' C U, ' GA G3>

*ay B5 6.76 9Thursday:

-urCo has its first settlement date position3 T#o things happen3 "irst2 #e assume the trade settles 5for the fail situation2 see "ails63 econd2 #e accrue one day7s interest3 (e update our transaction information as follo#s4 $ettlement and !nterest Accrual on 6.76 Register ,ntries $ecurit 3.M y T%UG3> /

Aey

Type

*istribution

$ate4 =1FI >E>> E &@% EF2FF ;FE T C GIIM F > ' ;2FFF . &@P C GIIM ' EF . &@I C GIIM Aey $ate4 =1F= >E> ,T >E<< E > * >E<< >EI ,T E A * -;2FEF EF2FF F EF2FF ;2FEF F Associations A0 Type M A0 3

$ate4 =1FA >E>= E ,** T%UG3> EF2FF G=G / C T ;FE> F A G=G ' ;2FFF C . ,P A G=G ' E< C . ,I A

$ate4 =1F= >EIA E R,C T%UG3> EF2FF GII C * &-T F M GII ' ;2FEF C .C ) M / '> . &@I . &@A

>EM< E

ACCR T%U-INT* G3>

Register entry >EIA is the receive of the securities against payment of cash3 It closes the open &@% through Association >E<<3 Register entry >EM< is the interest accrual3 It increases Interest &ought 5&@I6 by :>2 #ith the other side being Interest Income 5&@A + the 8A8 standards for 8accrual863 If you #ere printing a trader P9* report2 you #ould sho# trader ;FE> earning interest income even though the trader has no 5trade date6 position3 &oth register entries have trade date and settlement date of =1F=3 Posting these entries results in the follo#ing positions and balances4 Positions 93: and Balances 9M: / as of 6.76 6.7 6.7 6.7 6.7 6.7 ?? 6.4 ?? 8 B C 6 > ? 7 ? T% T PRI ;F / T U, ' E> G3> T% T PRI GI / C U, ' IM G3> T% T PRI G= / C U, ' GA G3> & T% T PRI / * - U, ' T G3> T% T PRI & ;F ' . U, ' @P E> G3> T% T PRI & ;F ' . U, ' @I E> G3> & T% T PRI ;F ' .@ U, ' E> A G3> T% T PRI C ;F ' . U, ' ) E> G3> T% T PRI GI ' C U, ' IM G3> T 'PRI CG= T% , ' GA UFFF EF2F EF2F F FF FF F F F 33 F 3 33 F 3 33 3 33 3

FFF EF2F EF2F EF2F F FF FF FF FFFF FFFF F F

EF2F EF2F EF2F 33 EF2F 33 FF FF FF 3 FF 3 F 33 33 EF2F EF2F EF2F 3 3 FF FF FF 33 F 3 33 -= 3 33 -> 3 33 3 33 3 33 3

FFF

;2FF ;2FF F F F

F -= ->

F -= ->

FFFEF EF -< FFFF FFFF F F F F

33 33 ;2FE ;2FE ;2FE 3 3 F F F

33 33 FFF ;2FE ;2FE ;2FE F F F 3 3 F F F FFFF F ;2FE ;2FE ;2FE 33 ;2FE 33 < < < 3 < 3

Positions 93: and Balances 9M: / as of 6.76 6.7 6.7 6.7 6.7 6.7 ?? 6.4 ?? 8 B C 6 > ? 7 ? G3> T% PRI ;F / T U, ' E> G3> T% PRI GI / C U, ' IM G3> T% PRI G= / C U, ' GA G3> & T% PRI / * - U, ' T G3> T% PRI & ;F ' . U' @P E> G3> T% PRI & ;F ' . U' @I E> G3> & T% PRI ;F ' .@ U' E> A G3> T% PRI C ;F ' . U' ) E> G3> T% PRI GI ' C U' IM G3> T% PRI G= ' C U' GA G3> EF2F EF2F 33 F FF FF 3 F F F F 33 F 3 33 3 33 3

FFFF FFFF FFFF FFFF

F F F F

F F F F

33 EF2F 33 3 FF 3

33 33 EF2F EF2F EF2F 3 3 FF FF FF ;2FF ;2FF 33 F F F 3 E> E> -> -> 33 -= 3 33 -> 3 33 3 33 3 33 3

, , , , , ,

FFFF FFFF FFFF FFFF FFFF FFFF

F F F F F F

F F F F F F

33 33 ;2FE ;2FE ;2FE 3 3 F F F F F F F 33 F 3 33 3

33 ;2FE 33 3 < 3

Though the interest is accrued on a settlement date basis2 the resulting Cournal entry updates both date bases 5this is true for all register entries63 %ou may not be interested in the trade date interest income2 but that is a reporting issue2 not a database issue3 Position and &alances discusses ho# this information is managed #ithin the "rame#ork3

*ay C5 6.7> 9&riday:

There is no trading or settlement activity on =1FG 5the outstanding ,** reaches settlement date on =1EF63 &ecause =1FG is a "riday2 #e #ill accrue I days of interest2 or :=3 The register entry #ill have trade date and settlement date of =1FG3 !nterest Accrual on 6.7> Register ,ntries $ecurit 3.M *istribution y T%UG3> EF2FF ;FE T C GIIM F > ' ;2FFF . &@P C GIIM ' EF . &@I C GIIM /

Aey

Type

$ate4 =1FI >E>> E &@%

$ate4 =1FA >E>= E ,** T%UG3> EF2FF G=G C T ;FE> F A G=G ' ;2FFF C . ,P A G=G ' E< C . ,I A / Aey $ate4 =1F= >E<< >E<< >E> ,T E > * >EI ,T E A * -;2FEF EF2FF F EF2FF ;2FEF F Associations A0 Type M A0 3

$ate4 =1F= >EIA E R,C T%UG3> EF2FF GII C * &-T F M GII ' ;2FEF C .C ) M / '> . &@I . &@A

>EM< E

ACCR T%U-INT* G3>

$ate4 =1FG ACCR T%U>EAE E -INT* G3>

'=

. &@I . &@A

This leaves us #ith the follo#ing4 Positions 93: and Balances 9M: / as of 6.7> 6.7 6.7 6.7 6.7 6.7 ?? 6.4 ?? 8 B C 6 > ? 7 ? T% T PRI ;F / T U, ' E> G3> FFF EF2F EF2F F FF FF F F 33 F 3 33 3

Positions 93: and Balances 9M: / as of 6.7> 6.7 6.7 6.7 6.7 6.7 ?? 6.4 8 B C 6 > ? 7 33 FFF EF2F EF2F EF2F F F F 3 FF FF FF FFFF FFFF F F ?? ? 33 3

T% T PRI GI / C U, ' IM G3> T% T PRI G= / C U, ' GA G3> & T% T PRI / * - U, ' T G3> T% T PRI & ;F ' . U, ' @P E> G3> T% T PRI & ;F ' . U, ' @I E> G3> & T% T PRI ;F ' .@ U, ' E> A G3> T% T PRI C ;F ' . U, ' ) E> G3> T% T PRI GI ' C U, ' IM G3> T% T PRI G= ' C U, ' GA G3> T% PRI ;F T U' E> G3> T% PRI GI / C U' IM G3> T% PRI G= / C U' GA G3> & T% PRI / * - U' T G3> /

EF2F EF2F EF2F 33 EF2F 33 FF FF FF 3 FF 3 F 33 33 EF2F EF2F EF2F 3 3 FF FF FF 33 F 3 33 F 3 33 -< 3 33 3 33 3 33 3

FFF

;2FF ;2FF F F F

F -= ->

F F -<

FFFEF EF -< FFFF FFFF F F F F

33 33 ;2FE ;2FE ;2FE 3 3 F F F F 33 F 3 33 3

FFF ;2FE ;2FE ;2FE F F F F FFFF F

;2FE ;2FE ;2FE 33 ;2FE 33 < < < 3 < 3

, , , ,

FFFF FFFF FFFF FFFF

F F F F

F F F F

EF2F EF2F 33 F FF FF 3 F F F F 33 F 3

33 3 33 3

33 EF2F 33 3 FF 3

33 33 EF2F EF2F EF2F 3 3 FF FF FF

Positions 93: and Balances 9M: / as of 6.7> 6.7 6.7 6.7 6.7 6.7 ?? 6.4 ?? 8 B C 6 > ? 7 ? T% PRI & ;F ' . U' @P E> G3> T% PRI & ;F ' . U' @I E> G3> & T% PRI ;F ' .@ U' E> A G3> T% PRI C ;F ' . U' ) E> G3> T% PRI GI ' C U' IM G3> T% PRI G= ' C U' GA G3> ;2FF ;2FF 33 F F F 3 E> E< -> -< 33 F 3 33 -< 3 33 3 33 3 33 3

, , , , , ,

FFFF FFFF FFFF FFFF FFFF FFFF

F F F F F F

F F F F F F

33 33 ;2FE ;2FE ;2FE 3 3 F F F F F F F 33 F 3 33 3

33 ;2FE 33 3 < 3

*ay 65 6.47 9Monday:

This is settlement date for the ,**3 As discussed in Transaction -perations2 if the transaction fails to settle2 everything in the system #ould be e0actly as it is above on $ay A3 ,ven if the transaction fails2 #e #on7t accrue any interest because the trader7s settlement date position is flat and Interest &ought has the appropriate value 5Vero63 (e #ill go ahead and assume settlement2 reflected in register entry >EA< and association >E;I3 $ettlement on 6.47 Aey Type Register ,ntries $ecurit 3.M y T%UG3> / *istribution Aey $ate4 =1F= EF2FF T ;FE> C GIIM F ' ;2FFF . &@P C GIIM >E> ,T >E<< E > * -;2FEF EF2FF F Associations A0 Type M A0 3

$ate4 =1FI >E>> E &@%

$ettlement on 6.47 Aey Type Register ,ntries $ecurit 3.M *istribution y ' EF . &@I C GIIM

$ate4 =1FA >E>= E ,** T%UG3> EF2FF C G=GA T ;FE> F ' ;2FFF C G=GA . ,P ' E< C G=GA . ,I / Associations A0 Aey Type A0 3 M >EI ,T EF2FF >E<< E ;2FEF A * F

$ate4 =1F= >EIA E R,C T%UG3> /

>EM< E

ACCR T%U-INT* G3>

EF2FF C GIIM * &-T F $ate4 =1EF ' ;2FEF C GIIM . C ) >E> ,T >E;I E = * '> . &@I . &@A >EA ,T >E;I E < * '= . &@I . &@A

$ate4 =1FG ACCR T%U>EAE E -INT* G3> $ate4 =1EF >EA< E $,* T%UG3>

EF2FF F -;2FE< EF2FF F ;2FE<

EF2FF &* C G=GA F T ' ;2FE< . C ) C G=GA /

-ur final positions and balances are4 Positions 93: and Balances 9M: / as of 6.47 6.78 6.7B 6.7C 6.76 6.7> T% T PRI ;F / T U, ' E> G3> T% T PRI GI / C U, ' IM G3> T /PRI CG= T% , ' GA UFFF EF2F EF2F F FF FF F F ?? 6. ?? ? 47 ? 33 33 F 3 3 33 3 33 3

33 FFF EF2F EF2F EF2F F F F 3 FF FF FF FFFF F EF2F EF2F EF2F 33 F FF FF FF 3

Positions 93: and Balances 9M: / as of 6.47 6.78 6.7B 6.7C 6.76 6.7> G3> T% T PRI &/ * U, ' T G3> T% T PRI &@ ;F ' . U, ' P E> G3> T% T PRI &@ ;F ' . U, ' I E> G3> T% T PRI &@ ;F ' . U, ' A E> G3> T% T PRI C ;F ' . U, ' ) E> G3> T% T PRI GI ' C U, ' IM G3> T% T PRI G= ' C U, ' GA G3> T% PRI ;F T U' E> G3> T% PRI GI / C U' IM G3> T% PRI G= / C U' GA G3> T% PRI &/ * U' T G3> / ?? 6. ?? ? 47 ?

FFFF

33 33 EF2F EF2F F 3 3 FF FF 33 33 F 3 3 33 33 F 3 3 33 33 -< 3 3

FFF

;2FF ;2FF F F F

F -= ->

F F -<

FFFEF EF -< FFFF FFFF F F F F

33 33 ;2FE ;2FE < 3 3 F F F 33 33 F 3 3

FFF ;2FE ;2FE ;2FE F F F F FFFF F

;2FE ;2FE ;2FE 33 33 F < < < 3 3

, , , ,

FFFF FFFF FFFF FFFF

F F F F

F F F F

EF2F EF2F 33 33 F FF FF 3 3 F F F F 33 33 F 3 3 33 33 F 3 3

33 33 EF2F EF2F F 3 3 FF FF ;2FF ;2FF 33 33 F F F 3 3

T% PRI &@ ;F ' . UFFFF , ' P E> G3>

Positions 93: and Balances 9M: / as of 6.47 6.78 6.7B 6.7C 6.76 6.7> , , , , , T% PRI &@ ;F ' . U' I E> G3> T% PRI &@ ;F ' . U' A E> G3> T% PRI C ;F ' . U' ) E> G3> T% PRI GI ' C U' IM G3> T% PRI G= ' C U' GA G3> FFFF FFFF FFFF FFFF FFFF F F F F F F F F F F E> E< -> -< ?? 6. ?? ? 47 ? 33 33 F 3 3 33 33 -< 3 3

33 33 ;2FE ;2FE < 3 3 F F F F F F 33 33 F 3 3 33 33 F 3 3

As you #ould e0pect2 #e end up #ith an increase in cash of :<3FF and in interest income of :<3FF3

!nterest &iguration Routines

There are at least three conte0ts in #hich interest must be calculated4

Interest bought1sold 5often called 8accrued interest82 though that7s a bit of a misnomer6 on a trade3 Interest income1e0pense accrued at end of day on long1short positions3 Actual coupon payments3

(e sa# e0amples of the first t#o earlier3 In this section #e treat interest figuration more generally3 (e #ill not go into the complete details of the algorithms here 5those are covered in $ay Count Conventions62 but only highlight the maCor considerations3 (e #ill again discuss only buys1long positions2 but sells and short positions are completely analogous3 "ortunately the interest routines are normally e0pressed as the calculation of days bet#een t#o dates2 so they can be used for all three purposes3 The interest figuration routine #ill have to consider the follo#ing parameters4

$ay count convention3 This refers to such things as IF@1I=F and Actual1I=A3

&usiness day convention3 If the scheduled payment date falls on a non-business date2 you need to provide for adCustments3

These #ill be discussed in more detail belo#3

Trade !nterest Bought.$old

(e have seen that buying a bond 5or other fi0ed income instrument6 that has coupon payments normally includes buying an amount of interest that reflects ho# far you7re into a coupon period 5based on trade settlement date63 Periods run from the day after record date to the ne0t record date2 #ith interest bought on payment date e!ual to Vero3 In many markets 5e3g32 @ Treasuries6 the payment is on the day after record date2 so the interest bought starts at Vero and then increases3 If there is a gap bet#een record date and payment date2 you can have a period of negative accrued interest from the day after record date until it hits Vero on payment date3 To utiliVe the routines2 the start date of the range is the day after the record date immediately preceding the trade settlement date3 The end date of the range is the trade settlement date3 The e0ample #e7ve been discussing has payment on the day after record date2 so it has the same pattern as a @ Treasury 5first day of the period has Vero interest bought1sold63

!nterest !ncome and E pense

"irst2 recall that interest income and e0pense is based on positions2 not trades2 and that it is computed on a settlement date basis3 As #ith trading P9*2 Interest Income1,0pense is best thought of as the other side of an adCustment to the balance sheet2 in this case Interest &ought1 old3 In our e0ample #e spoke in terms such as 8one day7s interest82 but it is better to proceed by determining #hat the balance of Interest &ought1 old should be2 #ith the posting necessary to establish that value also determining Interest Income1,0pense3 %ou see this in the end-of-day settlement date balance for &@I on =1F=2 after the first accrual3 The balance is :E>3FF2 #hich is #hat the routine #ill actually calculate? the :>3FF of the Cournal entry is simply #hat is needed to get there3 The reasons for the balance sheet approach are much the same as for treating unrealiVed P9* on an inventory 5fair value6 basis rather than an income statement basis4

The balance sheet account is independently verifiable3 If you kno# the position you can easily calculate the re!uired value of Interest &ought1 old3 If you focus on the income statement2 there is nothing to verify it against3

It makes handling cancellations and corrections easier3 At the 5literal6 end of the day2 the difference bet#een #hat7s in the balance sheet account and #hat it should be is the Interest Income1,0pense2 by definition3 "or the same reason2 any errors in figuration are like#ise corrected on the balance sheet3 It avoids drift and rounding errors3 In particular2 it insures that values are correct #hen you go flat3

"ocusing on the balance sheet also brings the t#o figuration routines 5trade Interest &ought1 old and Interest Income1,0pense6 to a common footing3 *ooking at the balances in the earlier e0ample2 it appears as if the interest income1e0pense accrual is setting the Interest &ought1 old balance to the value it #ould be for a trade settling the follo#ing day to li!uidate the position3 (e sa# for the ,** that that is ho# it in fact #orked out3 To use the figuration routines2 proceed as #ith the trade Interest &ought1 old2 but set the ending date to the ne0t settlement date3 Note that this may not be the ne0t calendar day2 if the ne0t calendar day is a non-business day 5e3g32 holiday or #eekend63 There may be an adCustment for month end2 #hich #e cover belo#3 5As a check2 once you are flat you e0pect to see balances only in cash and one or more profit 9 loss accounts3 This is true not Cust for interest2 but for dividends2 trading P9*2 and any other P9* situation3 ee O"A &Con=P2 Y GI36 In terms of the sa#-tooth figure for Interest &ought1 old on trades #e referred to earlier2 the balance in the account after the end-of-day accrual #ould appear to be the same figure2 Cust shifted to the left to the ne0t business date3 This is indeed true at a conceptual level2 but there are t#o situations #here it does not hold3 0n Record *ate The Interest &ought1 old drops on trades #ith settlement the day after record date3 This is addressed in t#o steps4

-n record date accrue Interest &ought1 old based on the number of days to the day after record date 5#hich #ill be payment date in our e0ample63 The offset is to Interest Income1,0pense3 This is the standard Cournal entry and distribution3 "or e0ample2 before the accrual a position of EF2FFF in T%U-G3> on EE1IF 5the record date6 #ill have an Interest &ought1 old 5&@I6 balance of :EG< 5because #e are using IF days per month this is the ;Fth day of the period63 (e make a normal accrual to take it to the payment amount2 :E<F3 &@I Interest bought :> &@A Interest income :>

Create a Cournal entry for the full coupon amount2 against the inventory bought1sold account and coupon clearing account 5CPC63 This step is analogous to the SN* -$VI and SN* -$VT created for dividends3 CPC Coupon clearing :E<F &@I Interest bought :E<F

If payment date is not the day after record date2 the balance in &@I after the first step above #ill be less than the full coupon amount3 -ffsetting by the full coupon amount in the second step #ill result in a negative balance2 reflecting the negative accrued interest #e mentioned earlier3 Month End In the e0ample #e sa# that the accrual for "riday2 =1FG2 took Interest &ought1 old to the balance that #ill be credited by the ,** that #ill li!uidate the position on 'onday3 The Cournal entry #as for :=3 *ooking at it from an income and e0pense vie#point2 this is three days7 income3 The rule is slightly different if the ne0t business date is in the follo#ing month3 "or instance2 if the last day of the month is aturday2 the general accounting rule is to match the income to the month3 (e can change our e0ample so that the record date is =1>> rather than A1IE3 -ur first trade is done on =1>A2 settling =1><3 -ur "riday accrual #ill be done on =1>;3 Rather than accruing :=2 #e #ould accrue :M2 #hich takes Interest &ought1 old to :E= rather than :E<3 -ur ,** reaches settlement date on G1F>2 #ith a credit of :E< to Interest &ought1 old3 (e assume again that it settles normally3 In this changed e0ample2 at end-of-day on G1F> #e #ill have -:> in Interest &ought1 old2 the e0cess of the :E< credit over the :E= balance brought for#ard3 &ecause #e have a Vero position2 our routine #ill generate the follo#ing Cournal entry to flatten out Interest &ought1 old4 &@I Inventory bought :> &@A Interest income :> &esides flattening out the balance sheet2 of course2 it also credits us #ith the remaining :> in income3 ,ven though you have no settlement date position2 you are still recogniVing income3 The final positions and balances for G1F> #ill be e0actly the same as the =1EF values given earlier3

T'o 3uestions
There are numerous details associated #ith calculating interest in all its forms3 At this point it7s useful to take a step back and ask t#o fundamental !uestions4

(hy is there more than one method1conventionD And given that there are more than one2 #hy aren7t there even moreD (e discuss this in $ay Count Conventions3 (hy is there interest bought1sold on a trade in the first placeD (e discuss this in &ond Pricing3

*ay Count Con"entions Renting an Apartment

Consider renting an apartment3 A typical lease calls for a constant monthly rent3 The monthly payments are then simple3 )o#ever2 you can pay different amounts for one day7s rent2 depending on the length of the month3 This only comes into play if you move out before the end of the month3 @sually you #ill pay based on the pro rata share of the month3 If you leave on Suly EGth2 you #ould pay EG1IE of the monthly rent3 -n November EGth it #ould be EG1IF3 This is closest to Actual1Actual 5IC'A62 though you pay monthly rather than !uarterly3 )otel rooms are different2 basically being charged by the day3 This is similar to the Actual conventions Act1I=F or Act1I=A"3 The various algorithms are discussed in detail on the page $ay Count Conventions3 )ere #e look at the !uestion posed above4 #hy is there more than one methodD "irst2 there are inherent conflicts among the desired features3

Interest is based on the period the investment is held2 so #e #ould e0pect to earn the same amount #henever the investment is held for a given amount of time3 5(e #ill consider only long positions1buys2 but the shorts1sells are e0actly analogous36 &ut because months 5and years6 have a variable number of days2 it is not possible to have both a constant amount of interest earned each day and a constant amount each month1coupon period1year3 If you #ant to have a constant amount of interest per month 5and are #illing to have a variable amount per day62 you have a conflict bet#een interest bought and interest earned3

A number of groups 5in addition to the traders6 have an interest and their o#n set of goals4 !nterests 'anagement has the most interest in accuracy based on the amount of time 'anagement an investment is held3 This is particularly true as they vie# it in the conte0t of other interest1e0pense items3 The focus is on interest bought1sold and the ease in calculating it3 8,ase8 means not only simplicity2 but also consistency and the minimiVation of errors3 Trade corrections 5and B possibly B fails6 are very e0pensive to -perations process3 -perations also has a strong interest in calculating and processing coupon payments3 The focus is on interest income1e0pense3 ,ase is important2 but not to the Accounting degree it is for -perations3 @nderstanding the methods means understanding the conflicts and making decisions3 The first decision is the period5s6 you #ant to keep interest constant over3 2roup

*ecision5 Constant !nterest Period

There are basically three alternatives for the period for #hich you can have a constant interest increment3 Constant period $aily $aily by coupon period 'onthly !mplications Interest bought1sold on a trade goes up by the same amount every day3 This implies that the coupon payments and total annual income are not constant2 because of leap years3 Interest is constant for each day of a given coupon period2 and each period has the same coupon payment3 Payments are also constant by year3 -n the other hand2 one day7s interest may vary bet#een periods3 All months2 and thus coupon payments2 are constant2 but the days aren7t3

*ecision5 *etermining *aily !nterest

&onds are !uoted on an annual interest basis2 e3g32 E>H per year3 The ne0t step is to determine the daily interest rate3 "or the 8$aily8 alternative above2 the most common approaches are to divide the !uoted interest rate by I=F or I=A3 I=F is slightly easier on the math and is the more common3 %ou could use any fi0ed number 5even I=A3>A62 but only I=F and I=A are used in practice3

"or 8$aily by coupon8 you first divide the !uoted rate by the number of coupon periods in a year3 %ou then divide that result by the number of days in the particular period 5e3g32 E<> or E<I for a semi-annual coupon63 "or 8'onthly8 you divide the !uoted rate by I=F and take a standard IF days per month3 "or argument7s sake you could use IM< #ith >; days per month2 but in practice only I=F #ith IF are used3 Note that none of these approaches take compounding into account3 The follo#ing table summariVes the discussion to this point3 $ay Count Convention Comparison Chart *ay Count Constant dollars per Constant Con"ention period Period *ays.Mo *ays.)r ;.*ay ;.Mo ;.Cpn ;.)r $aily $aily Actual Actual I=F I=A %es %es No No No No No No

$aily by coupon period

Actual

Actual

#1in pd No

%es

%es

*iscussion 'ethod used for repo interest3 This is Act1I=F3 &asically similar to the above 5Act1I=A 5"i0ed663 ,ach day in a given coupon period has the same interest2 but may be different for other periods3 It is commonly used for @ Treasury securities 5Actual1Actual 5IC'A663 The most common method for corporate bonds 5the IF1I=F conventions63 (e discuss the meaning of 8 plit8 belo#3

'onthly

IF

I=F

plit

%es %es

%es

To take one ro# as an e0ample2 the Actual1Actual method assigns a constant amount of interest to each day within a given coupon period3 The amount per month is not constant2 though the amount per coupon period and year is3 The only remaining issue is the determination of the 8 plit8 for IF1I=F3

*ecision5 87.867 *aily !nterest $plit

As can be seen in the table above2 the IF1I=F day count convention has a number of very nice attributes3 &ut there is a problem #ith handling daily interest3

The problem2 of course2 is that you #ant to have constant monthly interest2 but the number of days per month is not constant3 -ne approach #ould be to divide the !uoted annual interest rate by E> to get a constant monthly rate2 and then divide that rate by the actual number of days in the month3 The problem #ith this approach is operational4 it is too easy to make errors in the computation2 and errors are very e0pensive to correct3 The approach used in practice is to assign IF days to each month3 If the month has more or fe#er days2 an adCustment is made at the end of the month so that each month gets e0actly IF days of interest3 (e consider t#o common methods used in practice to handle that 8adCustment82 reflecting conflicting emphases on interest bought and on interest earned3 These are illustrated in the table belo#3 The first ro# is the IC'A 5,uropean6 standard 5IF,1I=F6 and the second is that used in the @ A 5IF@1I=F63 The third ro# belo# is the Actual1Actual used for @ Treasuries 5Act1Act 5IC'A663 In the table #e ignore the effects of non-settlement days and month-ends that #ere discussed above3 IF1I=F AdCustment Alternatives 5in days of interest6 E-Sun 333 IF-Sun E-Sul >-Sul 333 >;-Sul IF-Sul IE-Sul E-Aug >-Aug $ays of Interest &ought IF1I=F IC'A F 333 >; IF IE 333 A< A; A; =F =E IF1I=F @ A F 333 >; IF IE 333 A< A; =F =F =E Actual1Actual F 333 >; IF IE 333 A< A; =F =E => $aily Income IF1I=F IC'A IF1I=F @ A Actual1Actual

E E E

333 E 333 E 333 E

E E E

E E E

333 E 333 E 333 E

F E E

E F E

E E E

E E E

'onth-to-date Income IF1I=F IC'A E IF1I=F @ A E Actual1Actual E

333 IF 333 IF 333 IF

E E E

> > >

333 >; 333 >; 333 >;

>; IF IF

IF IF IE

E E E

> > >

The first block of ro#s sho#s the number of days of interest 5not the dollar amount of interest6 bought for a trade settling on the date given3 Sune Est is a coupon payment date2 so there is no interest on that day3 The ne0t t#o blocks of ro#s sho# daily interest 5again in days of interest6 and month-todate interest3 In all cases the interest bought on the second day of the month is one higher than on the first day2 #ith each day increasing until the adCustment point is reached3 The IC'A and

@ approaches differ in the relative importance given to interest bought and to interest earned3 "or months #ith less than IE days the approaches are identical2 so #e discuss only months #ith IE days belo#3 Actual1Actual simply keeps going up each day3 !nterest Bought The IC'A approach results in a more intuitive figuration of trade interest bought2 #hich is a benefit to -perations and Trading3 Interest bought increases each day until the last day of the month2 #ith the IEst being unchanged from the IFth3 It then goes up on the first of the ne0t month by one day3 @nder the @ approach2 it goes up through the IEst2 and the first of the ne0t month has the same value as the IEst2 before it starts increasing again on the >nd day of the follo#ing month3 Month-to-date !nterest !ncome The @ approach is more intuitive for interest earned4 interest income goes up each day through the IFth2 #ith the amount unchanged on the IEst3 This results in clearer P9* reporting3 @nder the IC'A it increases through the >;th2 stays unchanged on the IFth2 and then goes up again on the IEst3 .iven the relation of interest earned to the follo#ing day7s interest bought discussed in an earlier section2 this situation is unavoidable3 %ou can7t have both intuitive interest bought and intuitive month-to-date interest income3

Remarks
(e started this discussion of day count conventions by emphasiVing the utility of understanding the reasons the various conventions #ere first developed3 They #ere all developed to be suitable for a particular purpose 5not Cust to confuse programmersZ63 If you understand the reasons2 you should be able to develop the algorithms from scratch3 As to #hy there aren7t more2 there are3 It7s a balance among the goals of those involved in the marketplace3 It7s a dynamic process3 It is also important to remember that these methods #ere developed before computers #ere available3 A method like IF1I=F2 #hile 8difficult8 for programmers2 has tremendous benefits for traders2 operations2 finance2 and investors3 "inally2 bond coupons do not e0ist in an investment vacuum3 If you finance a corporate bond purchase via a repurchase agreement2 the bond #ill typically earn interest on a

IF1I=F basis2 #hile the repo incurs an e0pense on an Actual1I=F basis 5because repos don7t have periodic payments2 the variability per month and year is not a dra#back63

*i"idend Comparison
$ividends are very similar to coupon payments at an architectural level3 These are the only differences4 $eclaration date is effectively the bond issue date2 as the dates and amounts are described in the bond prospectus3 The !uantity sub-type *-N 5stock loan6 is changed to &*-N 5bond loan63 The account codes are changed as follo#s4 *i"idend account Coupon account Comment $VC CPC The clearing account $VI &@I $ividend income [ Interest bought $VT ,I $ividend e0pense [ Interest sold The Register Types change as follo#s4

*i"idend register Coupon register Comment SN* -$VI SN* -&@I Sournal for long trader positions SN* -$VT SN* - ,I Sournal for short trader positions $IV -PA% CPN -PA% Coupon payable $IV -R,C CPN -R,C Coupon receivable The one area that changed is the trial balance 5you may have noticed that #e changed $ividend Income to Interest &ought2 not to Interest Income63 &ut everything else carries over directly4 the actions of the issuer and custodian2 trader longs and shorts2 safekeeping2 fails2 borro#s and loans2 and the &o03