How to Calculate Accrued Interest for the Series 7 Exam
When taking the Series 7 exam, you need to be able to calculate the number of days of accrued interest that the buyer owes the seller. Although you can calculate the accrued interest with a few different methods, here is one of the simplest ways.
When investors purchase bonds in the market, they may have to pay an additional cost. The additional cost is called accrued interest. Accrued interest, which is due when bonds are purchased between coupon dates, is the portion of the interest still due to the seller.
As you may remember, bonds pay interest once every six months. If an investor holds onto a bond for five months out of a six-month period, he is entitled to 5/6 of that next interest payment; that’s accrued interest.
Accrued interest on corporate and municipal bonds is calculated on a 360-day year and assumes 30-day months. Accrued interest on U.S. government bonds is calculated using the actual days per year and the actual days per month.
The following sample question tests your ability to figure out this prorated amount.
Skippy Skippington III purchased a 6-percent corporate bond on Friday, October 21. The coupon dates are January 1 and July 1. How many days of accrued interest does Skippy owe?
The answer you want is Choice (A). You have to begin your calculations from the settlement date (the date that the issuer records the new owner’s name). Corporate and municipal bonds settle in three business days. You’re thrown a slight curveball in this question because you have to contend with a weekend.
Accrued interest is calculated from the previous coupon date up to, but not including, the settlement date.
Now you’re probably asking yourself, What the heck does that mean? There is a nice, easy way to calculate the answer. Using the preceding example, assume that the settlement date is October 26. You would write it as 10/26 (tenth month and 26th day). The previous coupon date would be 7/1 (July 1). You can now set up a subtraction problem:
3/25 (3 months × 30-day months) + 25 days = 115 days of accrued interest
First subtract the seventh month (July) from the tenth month (October). You end up with three months.
Because corporate and municipal bonds calculate accrued interest using 30-day months, you have to multiply three months by 30 days to get an answer of 90 days. Subtract the previous coupon date (1) from the settlement date (26) to get an answer of 25 days. Add the 90 days and 25 days together, and you get 115 days as your answer.
Read carefully. To try to trip you up, the Series 7 exam writers may include the settlement date in the question. If this is the case, you don’t need to add days to the trade date.
You can use the same formula to calculate accrued interest on U.S. government securities. However, U.S. government securities settle in one business day, not three. Additionally, U.S. government securities are calculated using actual days per month. The following example shows you how to calculate interest for a U.S. government securities question.
Skippy Skippington IV purchased a 5 percent T-bond on Monday, November 18. The coupon dates are January 1 and July 1. How many days of accrued interest does Skippy owe?
The right answer is Choice (C). Take a look at the following calculations:
11/19 The T-bond settled in one business day
–7/1 The previous coupon date
4/18 (4 months × 30-day months) + 18 days = 138 days + 3 days for July, August, and October = 141 days of accrued interest
To get the settlement date, you have to add only one business day. Because the trade date is Monday, November 18, the settlement date is Tuesday, November 19 (11/19).
Next, subtract the previous coupon date of July 1 (7/1), and you get an answer of 4 months/18 days. If you multiply the months by 30 and add the days, you end up with 138 days. At this point, you add one day for each of the months that have 31 days (July, August, and October). Your answer is 141 days.
Your 31-day months are January, March, May, July, August, October, and December. All the rest of the months have 30 days, except for February, which has 28. For February, you subtract two days. You may ask, What about leap year? It’s virtually unknown for a someone to get a leap-year question yet, but if you’re that unlucky person, subtract only one day for February.