Chartered Financial Analyst (CFA) Practice Exam Level 2

What is the difference between Clean Price and Dirty Price of a bond?

1. Clean Price includes accrued interest while Dirty Price does not.

2. Dirty Price includes accrued interest while Clean Price does not.

3. Both prices include accrued interest.

4. Both prices exclude accrued interest.

The correct answer is: Dirty Price includes accrued interest while Clean Price does not.

The distinction between the Clean Price and the Dirty Price of a bond is crucial for understanding how bonds are priced and traded. The Clean Price is the quoted price of the bond that excludes any interest that has accrued since the last coupon payment. It represents the present value of the bond's future cash flows, discounted back to the current date without considering accrued interest. On the other hand, the Dirty Price, also referred to as the full price, includes the accrued interest along with the Clean Price. This means that when one purchases a bond, they pay the Dirty Price, which reflects the total cost to acquire the bond, as it incorporates the compensation to the current holder for the portion of the interest period that has elapsed since the last coupon payment. Understanding this distinction is important for investors, as it affects cash flows and the financial reporting of bond holdings. When a bond is traded between coupon payment periods, the seller is entitled to the accrued interest for the period the bond has been held, which is factored into the Dirty Price.