BTRM Working Paper Series, #14

Bond Markets: "Dirt" in the Clean Price, September 2020

Bond market pricing follows age-old and time-honoured principles of corporate finance and present value. A dealer of fixed income securities focuses on yield, and the price is calculated by using the PV principle. Accuracy is taken for granted. However the whole concept of bond mathematics makes a number of assumptions, which are not necessarily realistic.
The author finds two discrepancies in the calculation of dirty price and accrued interest
which causes the clean price to be distorted. He shows how and why the formulae used are incorrect, and that the present value factor is over-estimated by the use of inappropriate formulae. This results in over-payment of the dirty price to the seller. Within the dirty price, there is over-payment on account of accrued interest, with the issue being that often full accrued interest is paid instead of its present value. Both these factors distort the clean
price, leading to improper accounting of the transactions.
The author suggests a modified compounding formula to rectify the distortions. Both the existing and suggested formulae have been tested for their accuracy. The author concludes by discussing comparative advantages of using the modified compounding formula and the practical implications for fixed income fund managers. 
by K. Boovendran