The process determines the amount of interest that has accumulated on a bond since the last interest payment date. This calculation is essential when a bond is bought or sold between coupon payment dates. The buyer compensates the seller for the interest earned up to the transaction date, as the next full coupon payment will be received by the buyer. As an illustration, consider a bond with a semi-annual coupon payment schedule. If the bond is sold two months after the last coupon date, the buyer owes the seller the interest that accumulated during those two months. This amount is added to the market price of the bond to arrive at the total price paid by the buyer.
This calculation ensures fairness in bond transactions. Without it, the seller would lose the interest earned before the sale, and the buyer would receive unearned interest. Moreover, it provides clarity and transparency in the market, fostering trust among investors. The historical context stems from the need for accurate accounting and consistent valuation in bond markets, particularly as trading volumes increased and complexities in investment strategies grew.
