Accrued Interest is the portion of a debt securities future interest payment, which has been earned by the seller of the security. The purchaser must pay this amount of accrued interest to the seller at the time of the transaction’s settlement. Interest accrues from the date of the last interest payment date up to, but not including, the transaction’s settlement date.
Applying "Accrued Interest" to Securities Exams:
Interest on a bond accrues daily and is paid to the bondholder on a semiannual basis. When a customer buys a bond in the secondary market the buyer may owe the seller accrued interest on the bond. For example:
A customer buys one J&J corporate bond on Tuesday Aug 17.
The bond pays interest on January 1st and July 1st, and corporate bonds assume that each month has 30 days and there are 360 days in a year.
The bond last paid interest on July 1, so the buyer owes 30 days accrued interest for July.
The bond trade will settle on Aug 19, so the buyer owes an additional 18 days accrued interest for August.
Therefore, the buyer owes the seller a total of 48 days worth of accrued interest when the trade is settled.
To determine the amount of accrued interest owed to the seller, The formula is as follows:
Principal x Rate x Time
In our example above, if the bond paid 8 percent per year, we know that the bond wound generate $80 per year in income. This is found by multiplying the principal amount of the bond of $1,000 by the interest rate of 8 %. The principal amount of a bond is always $1,000 unless otherwise stated. To determine the total dollar amount of accrued interest owed, we must take that $80 and multiply it by the amount of time for which accrued interest is owed. In the above example the buyer owed 48 days worth of accrued interest. $80 X 48/360 = $80 X .133 = $10.67. This is the amount of the accrued interest the buyer owes the seller. The amount of accrued interest will be added to the amount paid to the seller at settlement.
Treasury notes and bonds use the actual calendar days in the month and a 365 day year. Treasury securities also settle on the next business day. So for a trader executed on any Weekday between Monday and Thursday, interest will accrue up to the trade date. A trade executed on Friday will continue to accrue interest for Saturday and Sunday