In fixed income markets, traders think of bonds in terms of clean and dirty prices, and this is how bond prices are quoted.
Clean Price of a Bond is the present value of the bond’s future cashflows minus the interest earned on the bond between the last payment date and the transaction date.
It is also simply defined as the price of a bond not including any accrued interest.
Clean Price = Dirty Price – Accrued Interest.
The Dirty Price is a bond pricing quote referring to the price of a coupon bond that includes the present value of all future cashflows, including interest accruing on the next coupon payment.
Accrued Interest is earned when a coupon bond is currently in between coupon payment dates. As the next coupon payment date approaches, the accrued interest increases until the coupon is paid. Immediately following the coupon payment, the clean price and dirty price will be equal.
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Other Differences between Clean Prices and Dirty Prices
Clean prices are more stable over time than dirty prices, as they aren’t affected by semi-annual rise and fall of interest accruing and being paid, as are dirty prices.
Clean prices can however be affected by economic factors such as changes in interest rates or changes in the issuer’s credit quality.
However, note that when a bond is bought and sold in the secondary market, it is the dirty price that is paid. That is the bond’s market value – so bonds are quoted as clean prices but transact as dirty prices.