222 MATHEMATICS OF FINANCE

10 years and [1000 + 20(t − 10)] after 10 years, ii) purchased at a premium or at a discount?
where t is the number of years after issue. Specify the amount.
a) What is the purchase price P to yield c) Using the purchase price in a), at what other
9% per annum compounded semi-annually time point could the bond be called to
assuming the bond is called at the end of produce the same yield rate? (Answer to
6 years? the closest integral number of years n
b) Is the bond from issue.)
i) redeemed at a premium or at a discount?
Specify the amount.

Section 6.5 Price of a Bond Between Bond Interest Dates

The bond purchase-price formulas (15) and (16) were derived for bonds pur-
chased on bond interest dates. In that case, the seller keeps the bond interest
payment due on that date, and the buyer receives all the future bond interest
payments. In actuality, bonds are purchased at any time and, consequently, we
need a method of valuation of bonds between bond interest dates.
In most cases, bonds are purchased on the bond market (bond exchange),
where they are sold to the highest bidder. Trading of bonds is done through
agents acting on behalf of the buyer and seller. The seller indicates the mini-
mum price he or she is willing to accept (ask) and the buyer the maximum price
he or she is willing to pay (bid). The agents, who work for a commission, try to
get the best possible price for their client. Many newspapers publish tables of
bond information, as illustrated on pages 225 to 226. The columns describe the
bonds as to issuer, bond coupon rate, and date of redemption or maturity. The
yields listed are calculated assuming the bond is purchased for the price bid and
held to maturity.
When a bond is sold between bond interest dates, the buyer receives all
future bond interest payments. However, part of the next bond interest payment
really “belongs” to the seller, for the seller owned the bond for part of the bond
interest period. We need to calculate the fractional part of the interest period for
which the seller owned the bond, and take this into account when determining
the price of the bond on the actual purchase date.
We will use the following notation in determining the value of a bond pur-
chased between bond interest dates to yield the buyer interest at rate i.
P0 = the purchase price of a bond on the preceding bond interest date to yield i
k = t he fractional part of the interest period that has elapsed since the preced-
ing bond interest date. (0 < k < 1)
no. of days between preceding bond coupon date and date off sale
=
no. of days between preceding bond coupon date and next bond coupon date
P = the full or dirty price, which is the total value of the bond on the actual
purchase date.
There are two ways to calculate the full price.
1. P = P0(1 + ki)
 Chapter 6 • Bonds 223

This formula assumes simple interest for the fractional period of time k.
However, in Canada (and the United States) this formula is seldom used in
practice any more.
2. P = P0(1 + i)k
This formula assumes compound interest for the fractional period of time, k,
and is the formula used in practice, and in this text.

Example 1 A $1000 bond, redeemable at par on October 1, 2012, pays bond interest at
j2 = 10%. Determine the purchase (full or dirty) price on June 16, 2010, to
yield j2 = 9%.
Solution Bond coupons are paid on April 1 and October 1. The preceding bond interest
date is April 1, 2010. The exact time elapsed from April 1, 2010, to June 16,
2010, is 76 days. The exact time from April 1, 2010, to the next bond interest
76
date on October 1, 2010, is 183 days. Thus, k = 183 .
+ 1000
Date of sale 50 50
…
0 1 5
April 1 June 16 Oct. 1 Oct. 1
2010 2010 2010 2012

P0 P

Using formula (16),

P0 = 1000 + (50 − 45)a5 0.045 = $1021.95
Using the compound interest formula
76
P = P0 (1 + i )k = 1021.95(1.045)183 = $1040.80

If we were to graph the full price of a bond, we would see a “sawtoothed”

effect, as presented on the following page. As we approach each bond interest
date, the full price or actual selling price of the bond increases to give the seller
the accrued value of the next bond interest payment or the accrued bond inter-
est, which is equal to

I = k ⋅ Fr

In our example,
76
I = 183 (50 ) = $20.77
At each bond interest payment date, the accrued bond interest is zero
and the price of the bond returns to the lower line marked Q. Q is called the
224 MATHEMATICS OF FINANCE

clean price or market price of the bond and is the price that is quoted in the
daily paper. Q does not rise and fall as P does.
From the graph, we can see that P = Q + I or

Q=P−I

In our example,
Q = $1040.80 − $20.77 = $1020.03
1070

1060
Fr = 50
1050

1040

I = 20.77
1030

1020

1010 Q = 1020.03

1000
April 1 June 16 Oct. 1 April 1 Oct. 1 April 1 Oct. 1
2010 2010 2010 2011 2011 2012 2012

Note that under the compound interest for fractional durations assumption it
looks like the value of Q moves along a straight line from one coupon date to
the next. This is not quite true as Q actually moves along in a slightly curved
fashion, especially as it gets closer to a coupon date.
Since bonds are issued in different denominations, it is customary to give
the quoted price q on the basis of a $100 bond.

Example 2 A $1000 bond paying interest at j2 = 9 12 % is redeemable at par on August 15,

2031. This bond was sold on September 1, 2010, at a quoted price of 103.13.
What did the buyer pay?
Solution We have q = 103.13. The clean (or market) price is Q = 10 × $103.13 =
$1031.30.
184 days

17 days

Aug. 15, Sept. 1, Feb. 15,

2010 2010 2011

Date of sale
 Chapter 6 • Bonds 225

The accrued bond interest from August 15, 2010, to September 1, 2010, is
17
I = 184 × $47.50 = $4.39
and the full purchase (dirty) price is
P = Q + I = $1031.30 + $4.39 = $1035.69

Example 3 A $500 bond, paying interest at j2 = 8%, is redeemable at par on February 1,

2019. What should the quoted price be on November 15, 2010, to yield the
buyer 9% compounded semi-annually?
Solution 184 days
106 days +500
20 20
… i = 4 12 %
0 1 17
Aug. 1 Nov. 15 Feb. 1 Feb. 1
2010 2010 2011 2019

P0 P

The purchase price on August 1, 2010, to yield j2 = 9%, would be

P0 = 500 + ( 20 − 22.50)a17 0.045 = $500 − $29.27 = $470.73
The full (dirty) price on November 15, 2010, to yield j2 = 9%, would be
106
P = P0 (1 + i )k = 470.73(1.045)184 = $482.82
The accrued bond interest from August 1, 2010, to November 15, 2010, is
106
I = 184 × $20 = $11.52
The clean (market) price on November 15, 2010, would be
Q = P − I = $482.82 − $11.52 = $471.30
Reducing Q to a $100 bond we get the so-called quoted price
471.30
q= 500 × 100 = 94.26

Canadian Bonds Canada 6.000 2011-Jun-01 106.52 0.76

Canada 8.500 2011-Jun-01 109.72 0.69
Bond values as of February 25, 2010 (website:
Canada 1.000 2011-Sep-01 100.06 0.96
CanadianFixedIncome.ca) Canada 3.750 2011-Sep-01 104.15 0.96
Coupon Maturity Price Yield Canada 1.250 2011-Dec-01 100.20 1.13
Gov. of Canada and Agencies Canada 1.500 2012-Mar-01 100.46 1.27
CMHC 5.500 2012-Jun-01 108.68 1.56
CMHC 4.300 2015-Apr-01 107.43 2.72 Provincials and Agencies
CMHC 4.250 2016-Feb-01 107.50 2.86 Alberta 4.250 2012-Jun-01 106.22 1.43
Canada 3.750 2010-Jun-01 100.92 0.13 Alberta 2.750 2014-Dec-01 100.47 2.64
Canada 5.500 2010-Jun-01 101.36 0.12 Alberta 4.000 2019-Dec-01 100.86 3.89
Canada 4.000 2010-Sep-01 101.89 0.21 Alberta 4.500 2040-Dec-01 99.92 4.50
Canada 2.750 2010-Dec-01 101.77 0.40 AlbertaTreas 4.100 2011-Dec-01 105.06 1.17
Canada 1.250 2011-Jun-01 100.60 0.77 AltaCapFinAu 4.350 2016-Jun-15 106.40 3.22

Continued