A:

A day-count convention is a system used in the bond markets to determine the number of days between two coupon dates. This system is important to traders of various bonds because it affects how the accrued interest and present value of future coupons is calculated.

The notation used for day-count conventions shows the number of days in any given month divided by the number of days in a year. The result represents the fraction of the year remaining that will be used to calculate the amount of future interest owed. Here are the most common day counts used in bond markets and the securities to which they typically apply:

30/360 - This is the easiest convention to use because it assumes that there are 30 days in every month, even though some months actually have 31 days. For example, the period from May 1, 2006 to August 1, 2006 would be considered to be 90 days apart. Given the simplicity of this day-count convention, it is often used in calculations of accrued interest for corporate, agency and municipal bonds. It is also commonly used by investors of mortgage-backed securities.

Actual/360 - This convention is most commonly used when calculating the accrued interest for commercial paper, T-bills and other short-term debt instruments that have less than one year to expiration. It is calculated by using the actual number of days between the two periods, divided by 360.

Actual/365 - This convention is the same as the actual/360, except that it uses 365 as the denominator. This is used when pricing U.S. government Treasury bonds.

Actual/Actual - This convention uses the actual number of days between two periods and divides the result by the actual number of days in the year, rather than assuming that each year is made up of 360 or 365 days. Of course, we know that in reality there are always 365 days in a year - with the exception of leap years - but these conventions are standards that have developed over time and help to ensure that everyone is on an even playing field when a bond is sold between coupon dates.

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