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Distinguish between the clean and dirty price of bond Bonds are long-term securities with a maturity of greater than a year

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Introduction

Distinguish between the clean and dirty price of bond Bonds are long-term securities with a maturity of greater than a year - normally the original maturity is well above one year and can be over 20 years, but some government bonds are irredeemable. The main issuer of bonds in the UK is the government. Therefore, when people invest in a bond people are actually loaning money to an entity, be it to the government. As 'compensation' of the investment, interest is paid to the bonds. The interest rate of bonds is a fixed rate of interest, at set intervals until maturity, called a coupon, which is paid in two installments, semi-annual. Simply the price of a bond is the present value of its expected cash flows. The present value is normally lower than the future value. For example, if a person is holding �100 today without spending, the value of �100 in the time of a year will not be as same and be likely less than the value of �100 today. Thus there is a convention to calculate the future value in certain period (see 1.1 below) ...read more.

Middle

2. The next coupon is exactly one year away. In the calculation of P0, it is assumed that last coupon payment has been just been made by the assumption, the next coupon is exactly one year away. However, bonds may be traded and priced at dates which lie between 2 coupon payments. So when a bond is bought or sold midway through a coupon period, a certain amount of coupon interest will have accrued. The coupon payment is always received by the person holding the bond at the time of the coupon payment, because the person may not hold the bond until the next coupon payment is made. Therefore, when a trade of a bond lied in the period of coupon payment is made, the buyer must compensate the seller for the fraction of the next coupon payment the seller is due but will not receive. This amount is called accrued interest. In order to calculate the accrued interest, the number of days since the last coupon, coupon interest and the total number of days in the coupon period. ...read more.

Conclusion

� Pb = Clean Price of Bond � t = years to maturity (2.2) Therefore, Ys = { ( 7 / 94.58 ) + ( 100 - 94.58 ) / ( 8 * 94.58 ) } * 100 = { 0.0740 + ( 5.42 / 756.64) } * 100 = ( 0.0740 + 0.0072 ) * 100 = 0.0812 * 100 = 8.12(%) The simple yield of the bond is 8.12% The simple yield is more sophisticated measure of return than current yield. Simple yield take into account capital gains or losses, resulting from the difference between the current price of the bond and its value upon maturity while current yield takes no account of the potential capital gains or losses. But simple yield does not take into account accrued interest as it uses the clean price in the equation. However, current yield can be used as a measure of value when the period of maturity is very long - when the coupon income will be more important in the total return than capital gains and losses and simple yield can be used in the case of what a bond in its final coupon period is directly comparable with a money market instrument. ...read more.

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