A bond is a debt security. The general convention in most bond markets is to quote the clean price. However as the bond could have accumulated interest from the last coupon payout at the time of sale, the dirty price is the real price paid. Simply put, the bond price without any interest is the Clean price, while the Dirty price is the bond price plus interest.
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What is Dirty Pricing?
In financial terms, the dirty price refers to the price of a coupon bond that includes the present value of all future cash flows, including interest accumulated on the next coupon payment. When the cost of a bond includes accrued interest based on the coupon rate, it is called a Dirty Price, which is a bond pricing quote. The coupon rate is the interest that is indicated on the bond when it is issued. The bond price quotes which are between coupon payment dates reflect the accrued interest up to the day of the quote. Basically, a dirty bond price includes accrued interest while a clean price does not. When investors buy fixed-income securities like bonds, they expect to receive coupon payments based on a fixed schedule. The price of a bond is dependent on the present value of future coupon payments. Unless a bond is purchased on the coupon payment date, this bond price likely includes the interest that has accrued since then. Therefore, the buyer would end up missing out on one coupon payment, and the seller will pocket the accrued interest – this would be a Dirty Price.
How is it determined?
If an investor decides to purchase a bond after the payment date, they won’t receive any coupon payments until the next payment date arrives. However, the bond seller may price a bond to include any accrued interest up to the sell date which is known as the Dirty Price. The price is referred to as “dirty” because even though the buyer will pay the price of the bond and the accrued interest, but he won’t get any coupon payments until the next payment date. Therefore, the accrued interest that was included earlier in the bond price will go to the seller.
Dirty Price is calculated using the formula given below;
Dirty Price = Clean Price + Accrued Interest
Clean Price = Dirty Price – Accrued Interest
To calculate both the prices the formula would be as follows:
Accrued Interest = Face Value * Total Annual Coupon Rate/ No. of Coupon Payments Per Year * Days since last payment date/ Accrual Period
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There’s nothing unsanitary about a bond’s “dirty” price. The dirty price compensates the seller for the accrued interest she’s earned but not yet received. The country wherein the coupon paying the bond is issued will impact how the bond is quoted. Some exchanges quote the dirty price of the bond whereas others quote the clean price. Therefore it is essential to know what kind of price is being quoted.
Author: Mahek Medh
About the Author: Currently, I am in my second-year bachelor’s program and over the period of time I have realized that I enjoy learning about numbers and money, and I find topics of Finance to very interesting thus this is the domain and space where I wish to etch my long term career.