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Finance Calculation Guide Book

Finance Calculation Guide Book

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Published by Khom Sakhan

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Published by: Khom Sakhan on Nov 29, 2010
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The different conventions used in different markets to relate price and yield
are just that – different conventions. They should not affect the economics of
an instrument. If the market convention is to trade a particular instrument in
terms of yield rather than price, the investor must first convert this yield to a
price using the appropriate conventions. The economics of the investment are
then determined by what the price actually is and what the future cashflows
are. From these, to compare two investments, the investor can ignore the
yield quoted by the market and use a single consistent approach of his/her
choice to calculate yields for comparison. In the next chapter we see how, in
reverse, he/she can calculate a price for each investment using zero-coupon
yields; again, this can be done consistently, ignoring market conventions.

100

52.605014 =

(1 + yield)256

365+7

0.08522

(1 +

)– 1 = 8.701%

2

Continuing from the previous example:

MORE TYPE ANN EXIT
MORE YLD%

OR

52.605014 ENTER 100 ÷
256 ENTER 365 ÷7 + ■■1

/x■■ ∧

■■1

/x1 –

Part 2 · Interest Rate Instruments

106

Summarising the issues we have already seen, the following factors need to

be considered.

Day/year convention for accrued coupon

This is ACT/365 (for example, Norway), ACT/ACT (France), 30(E)/360
(Germany) or 30(A)/360 (US federal agency).

Day/year convention for discounting cashflows to the dirty price

This is often the same as for accrued coupon, but may not be (Italy). For a
consistent calculation disregarding market convention, ACT/365.25 might be
used to compensate on average for the distorting effect of leap years.

Adjustment for non-working days

Conventional bond calculations generally ignore the effect of non-working
days, assuming coupons are always paid on the regular scheduled date (even
if this is not a working day). This approach is not taken with medium-term
CDs. The UK Stock Exchange calculations for gilt prices for example how-
ever, have in the past discounted to the dirty price using actual payment
dates for the cashflows.

Simple interest v. compound interest

In some markets, the yield for a bond in its final coupon period is calculated
on the basis of simple interest (US). For bonds with more than one coupon
remaining, compound interest is usual, although it is possible for example to
take simple interest for the first fractional coupon period compounded with
periodic interest thereafter (the US Treasury’s calculation method for new
issues). For a medium-term CD, simple interest discount factors for each
period are compounded together.

Compounding method

It is usual to discount bond cashflows by compounding in “round” years.
Using the same notation as earlier in this chapter, the discount factor is
1W + a number of whole coupon periods

( )

.A more precise approach is to use the total

1 +i
n

exact number of days to each cashflow rather than a round number of years:

a factor of . For medium-term CDs, the approach is

is to compoundeach exact time separately.

Other considerations

One basic question is whether a yield is quoted annually, semi-annually or
quarterly. The usual convention is to quote an annual yield if the coupons
are paid annually, a semi-annual yield if the coupons are paid semi-annually
etc. Care would need to be taken for example in comparing a semi-annual

total days to cashflow

i

×n

year

(1 +)
n

5 · Bond Market Calculations

107

yield for a UK gilt paying semi-annual coupons with a quarterly yield for a
gilt paying quarterly coupons.
The concept of a bond yield as an internal rate of return implies that all
coupons are also reinvested at the yield. An alternative is to assume a partic-
ular reinvestment rate (or series of different reinvestment rates). The coupon
cashflows are then all reinvested at this rate until maturity. The yield is then
the zero-coupon yield implied by the total future value accumulated in this
manner, and the initial bond price.

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