0
$\begingroup$

Cashflows from coupons and principal are discounted using the YTM to get PV of the bond in dirty price.

as shown here in this question Misunderstanding of 'day counts' and accrued interest

When backing out the clean price, the accrual is calculated as $coupon/freq*day/daycount$. But why do we linearly prorate the accrual?

Technically, shouldn't the accrued interest be the PV that is discounted by YTM of $coupon/freq*day/daycount$? The actual coupon amount will only be paid at the coupon date, so shouldn't the accrued interest take into account the time value between settlement date and coupon date?

Improve this question
$\endgroup$
2
  • 2
    $\begingroup$ I suspect the answer is practicality and ease of settlement. One could also adopt the philosophical view that since accrued interest is well defined and known before transaction the ultimate price paid for a bond may already included adjustments to offset any of these other effects. Additionally YTM is not a great measure anyway, different bonds have different YTMs due to curve shape - should one discount upcoming coupons on simialr dates on different bonds in different ways? $\endgroup$
    – Attack68 ♦
    Commented May 7 at 7:57
  • 1
    $\begingroup$ Another guess is that It is really just market convention. You are correct in that theoretically, it should be compounding. However, bonds existed before the proliferation of computers and calculators and therefore for simplicity, it was probably just agreed to understood by parties that interest should just be earned daily. $\endgroup$
    – AlRacoon
    Commented May 8 at 4:30

0

Reset to default

Browse other questions tagged or ask your own question.