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Business day conventions used for interest rate swaps & other derivatives

  
  
  
Resolution

When pricing an interest rate swap or another financial derivative, one of the first steps is generating a schedule of dates, based on the business day convention specified in the contract. 

In this post we will look at how dates would be generated using a variety of business day conventions.

Dates for our example swap:

  • Effective Date (Start Date): Feb 28, 2008
  • Maturity Date (End Date): Feb 28, 2011
  • Frequency: Semi-Annual

(1) No Adjustment

With no adjustment, coupons can land on weekends or holidays.

business day convention no adjustment

(2) Modified Following 

This is probably the most common business day convention used.  Cash flows that fall on weekends or holidays are assumed to be distributed on the following business day. However if the following business day is in a different month, the previous business day is adopted instead.

modified following business day

Note how in coupon #2 and #4 the dates are adjusted to the previous business date. While coupon #5 was adjusted to the next good business date. 

(3) Following

With following, coupons are adjusted to land on the next good business day.

following business day

(4) End of Month - No Adjustment

All cashflows are made on the last day of the month, even when it's a non-business day. In this example we used Feb 28, 2007 as our effective date, to show that in coupon #3, the coupon is paid out on the leap day Feb 29. 

end of month business day convention

Below we have outlined other business day conventions that you may come across. 

Summary of Business Day Conventions

 

Convention

Definition

 

No Adjustment

Business Holidays are effectively ignored. Cash flows that fall on holidays are assumed to be distributed on the actual date.

Previous

Cash flows that fall on a non-business day are assumed to be distributed on the previous business day.

Following

Cash flows that fall on a non-business day are assumed to be distributed on the following business day.

Modified Previous

Cash flows that fall on a non-business day are assumed to be distributed on the previous business day. However if the previous business day is in a different month, the following business day is adopted instead.

Modified Following

Cash flows that fall on a non-business day are assumed to be distributed on the following business day. However if the following business day is in a different month, the previous business day is adopted instead.

End of Month - No Adjustment

All cash flows are assumed to be distributed on the final day of the month (even if it is a non-business day).

End of Month - Previous

All cash flows are assumed to be distributed on the final day of the month. If the final day of the month is a non-business day, the previous business day is adopted.

End of Month - Following

All cash flows are assumed to be distributed on the final day of the month. If the final day of the month is a non-business day, the following business day is adopted.

generate-date-schedules-using-resolution

Comments

Many thanks for posting this article, it was of great help.
Posted @ Thursday, September 13, 2012 5:51 AM by Jacqueline Rulloda
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