Bond Market Conventions

While calculating present values of bonds, one may observe that some of the information required to compute the present value is actually missing from the question. However, this is not an error. One needs to understand that the examiner is in a way testing your knowledge of how the bond market works. In the bond market, some of the information is considered to be implied i.e. it is not explicitly communicated. This is called the bond market convention. Here is a list of some of the commonly used conventions in the bond market:

Face Value Convention: If the face value of the bond is explicitly given, then the explicit face value must be used. However, if the face value is not explicitly given then the implied value is either $100 or $1000. Students can choose any of these values as the face values. They may state this in their assumptions for deriving the solution. But that too may not be required because bond market convention dictates that these values must be considered the face value in the absence of appropriate data.

Interest Rates Are Semi-Annual: Once again, a student needs to check if the frequency of the interest rates has been explicitly mentioned. In case it is, then we must use the interest rates that correspond to the frequency. However, in case they are not given, we need to use semi-annual interest rates. Most bond markets across the world pay interest twice a year. Hence, it is a reasonable assumption to make. Changing the annual interest rate into a semi-annual one has a huge change on the present value of the bond.

Day Count Conventions: Day count conventions specify the number of days that a year contains according to the bond market. The number of days in a year is important to the calculation of the interest that has been accrued on the bond. The day count convention, however, is not uniform in bond markets across the world. Each market has its own convention and the trader must be aware of the type of convention being used in the specific market that they are concerned about. However, day count conventions can be broadly classified into 3 categories:

  • The year is assumed to be composed of 360 days
  • The year is assumed to be composed of 365 days
  • The year is assumed to be composed of the actual number of days i.e. 365 or 366 in a leap year

Interest Payments: Another convention that we need to discuss about is when the interest payment actually gets made. Now, once again this depends on the specific bond that is being considered. However, there are terms like EOM which denote that interest will be paid at the end of every month. Any student of bond valuation must be well versed with these terms as well as the implications that using these terms has on the valuation of the bond.

This list of conventions is obviously not comprehensive. There are many more conventions that may apply to all the markets across the globe or maybe specific to a given market. However, this article was meant to indicate that sometimes there might be information implied in the question even though one does not explicitly see the information mentioned.

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