How Day Count Convention Works

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Day count convention is a mathematical method of ascertaining the manner in which interest accrues in the course of a given period. This is in relation to various types of investments which include mortgages, medium-term notes, swaps, forward rate agreements, bonds, notes, and loans.

Altogether there are nine different methods that are scientifically recognized globally, of which in reality six methods are used. All these methods are based on the classic interest rate formulas, they differ only in the calculation of the number of days.

They specify the sum transmitted on interest payment dates, as well as the computing of accrued interest in connection with dates between payments.

The method is also applied for evaluating periods of discounting a cash-flow to its existing value. A seller can derive some portion of the coupon amount in the event that a security such as a bond is traded between interest payment dates.

Under the 30/360 or 30E/360 interest method (German (commercial)), the interest rate always includes 30 days, and 360 more days. In months ending with 31 days, the 30th is the final count day. For transactions ending in February, the days are counted with a maximum of 28/29 days. The base year (irrespective of the actual number of scheduled days) ends within 360 days.

United States interest rate method (30 (28-29) / 360), is based on the German commercial interest method, because the interest rate months are reported at 30 days and the interest period of 360 days.
On the other hand, the British interest rate method is determined on 365 or 366 days, as the interest rate year. The base year (regardless of the actual number of days) with 365 (unlike act/360) days scheduled. The first year will not bear interest, the last earns interest.

Under the ISMA rule ACT (specified day or effective interest method), the second ACT is in this case, actual = actual historical. The interest rate will be determined on 365 or 366 days of the interest rate year. The first year does not bear interest, and the last does.
In contracts, the calculation of interest has to be clarified and when payment processing falls on a weekend or public holidays, the next working day is fixed as the payment date.

The modified following business day also applies the principle of the following except in the event that the next banking day falls in another month. Then the previous business day is selected. This is strict adherence to the term not moving through to the following month – and staying in December of the same year.

If the interest rate determined by a 30 day contract periods and the modified following would result in the effective interest rate period of only 28 days, then a contractual adjustment is to be agreed. Since the different methods of calculating interest are due to the different maturities, considerable interest rate differentials may result in the same nominal interest rate.



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