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.
(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.
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.
With following, coupons are adjusted to land on the next good 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.
Below we have outlined other business day conventions that you may come across.
Summary of Business Day Conventions