Accrued Interest and Bond Prices

Abstract

Some Academics believe that the linear pro-ration of accrued interest transferred from the buyer to the seller when a coupon bond trades between interest payment dates leads to an overstatement of the full value of the bond and imputes a bias into conventional yield to maturity algorithms. This paper provides an analytical resolution to the debate about the correct role of the accrued interest component and demonstrates that current practice reflects the actual cash flows traded between bondholders. In addition, we show that yield to maturity calculations which incorporate linearly pro-rated accrued interest is unbiased.

JEL Classification: G12