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Flat - Full Price BUFN 732 Fixed Income Analysis
Bond price calculation In the following set up for the bond price: P is calculated as if the date of the cash exchange for the bond is t=0. In other words, we find the price of the bond as the PV of future cash flows as of t=0. However, the settlement date, the time when cash is exchanged for the bond, may not be at t = 0. The settlement date can be some time between t = 0 and t = 1. This real-life complication has implication for valuation.
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An example for bond price calculation Consider the example, This 5% bond makes coupon payments semiannually on June 15 and December 15. Suppose its YTM is 4% and this bond is purchased on June 15 (excluding the June coupon), but will settle on August 21. At that time, four coupon payments remain for the rest of the bond. June 15 Dec 15 June 15 Dec 15 June 15 $25 $25 $25 $25+$1000 Prof. Haluk Unal Fixed Income Analysis 4 An example for bond price calculation (cont’d) If the bond were to be exchanged for cash on June 15, the valuation would have been: However, the cash settlement is on August 21 (67 days after June 15): June 15 June 15 25+1000 Dec 15Dec 15June 15 August 21 183 days 67 days P = 25 1.02 + 25 1.02 2 + 25 1.02 3 + 25 + 1000 1.02 4 = $1019.04
An example for bond price calculation (cont’d) The value at settlement date ( the full price of the bond) is: Note that, this full price includes accrued interest between last coupon and settlement date. To figure out this accrued interest: In other words, the seller is entitled to this $9.15 interest because he/she has not received the cash till August 21. Full Price = 1019.04 ∗ 1.02 67 /183 = $1026.46 Accrued Interest = $25 ∗ ( 67 183 ) = $9.15
Calculation for full price Hence, the full price has two components: Full Price = Accrued Interest + Flat Price. Flat Price = Full Price - Accrued Interest = 1026.46 - 9.15 =$1017.31 Flat price is also called “clean” price meaning value that is free of accrued interest; Full price is also called “dirty” price because it includes elements of accrued interest. 1019.04 1026.46 = Full Price. Accrued Int = 9.15 25 25 25 25+1000 (This price includes the accrued interest on principal and the coupon.) 1017.31 Flat price 9.15 Accrued Interest on coupon
Calculation for accrued interest In calculating accrued interest, note that we used actual number days between coupon payments (183 days) and the actual number of days between the last coupon date and the settlement date (67 days). This actual/actual method is used most often with government bonds. Prof. Haluk Unal Fixed Income Analysis 8 Calculation for accrued interest (cont’d) There is another method that assumes there are 30 days in each month and 360 days in a year. In this method: June 15 Dec 15 25 25 25 25+1000 August 21 August 15 2*30 = 60 days 6 days 66 days 180 days Accrued interest = 25*(66/180) = $9.166 *Note that under the 30/360 method the accrued interest is slightly more.
Quotation conventions If the bond price is quoted clean price (flat price), this is not the price what you actually pay to buy the bond. You have to include the accrued interest in the price you pay, which is the dirty price (full price). Corporate and municipal bond issuers assume a 30/360 method. However, government bonds use actual/actual method. When the price of coupon bonds are quoted, they are either quoted at a full price or flat price. Bonds may trade at flat price if the bond settles on the same date as interest paid, so no accrued interest exist. Alternatively, bonds in default may trade at flat price.