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Dirty and Clean Prices

The debt market, both at a global and India level is second only to the foreign currency market in size and in India is probably the biggest in volume. This is in spite of the market being substantially a telephonic, or over-the-counter market. The equity market has been an exclusively electronic market, a feature that has helped it grow in volumes.

A very large part of the debt market volumes in India are of the government bonds, both short term Treasury Bills and long-dated bonds. The participants are almost exclusively institutions – banks, insurance firms, development institutions and mutual funds. These are well trained, finely focused teams with massive funds at their disposal and specific mandates in the kind and tenure of their investments.

The smaller part of the market is of the corporate bonds – short term paper in the form of Commercial Paper and bonds/ debentures for the longer term. Besides the institutions who are near monopolists in the government bond market, the small, retail investor has some participation in this market. (Retail participation in the “wholesale” market is of substantial size, primarily through mutual funds and insurance firms).

Dealing in huge volumes in markets such as equity or forex is simple relative to the fixed-income market. The latter has a small, specific component of the asset to be considered – the accrued interest.

Terms for interest calculation and payment vary with the bonds. There are a wide range of interest rates (some even varying each quarter, as with floating rate bonds), different coupon rests (time between payment of interest) and dates on which the interest accrues or is paid. Incorporating these into the price in a high-volume market is challenging. This is overcome by passing some of the efforts, post trade, to the back-office operations team.

The dealer in a bond trade enters into a transaction based on the base price of the bond calculated on the Yield-To-Maturity. This is a clean price transaction. A clean price transaction in a bond considers the cost of the bond, ignoring the accrued interest. This makes life less complicated for the dealer who has to consider only the price she pays for the desired yield on the bond. It also makes a bond very liquid for a trader who may want to hold the bond for just a few days, or even just minutes without having to spend much time on calculations.

A bond earns interest all the time, even when its owner is asleep. What happens to that interest? And the interest that has been earned on the paper when it was bought? Surely the person who held the bond is entitled to the interest. And is a buyer lucky to have purchased the bond just a day before interest payment?

The institutional settlement system is finely tuned and has a well-established process that ensures that the ultimate recipient of the interest coughs up the amounts due to previous holders of the paper.

This clean price system does not extend to the retail bond market. The retail investor is typically a buy-and-hold type, who seldom trades. She would normally hold a bond to its maturity. It would also be formidably difficult to involve the investor in collecting and disseminating the small portions of interest due to previous owners/ holders of the bond. The retail market, therefore, has the dealer (such as Tipsons) calculate the interest embedded in the bond based on the number of days the interest has accrued and add it to the price. This bond is traded at a dirty price.

A deep discount (or zero-coupon) bond passes the entire returns only along with the principal at the time of maturity. In such bonds, there is no difference between clean and dirty prices.

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