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Definition: Accrued Interest
Accrued interest is basically an accounting phenomenon which occurs due to the difference in timing of cash flows and the recognition of interest. This can be commonly seen in bonds, as they pay interest after a fixed interval say, six months whereas the interest is accrued on a day-to-day basis.
The basic formula for finding the accrued interest is as follows:
The major issue with the accrual of interest is the day convention used. Generally, a 30-day month and a 360-day year is used for corporate and municipal bonds whereas it is based on actual calendar days for Government bonds.
Assume a bond with face value of Rs. 100 and interest rate of 10% pays semi-annual interest payments.
Now, after 3 months,
Accrued interest = 100 x (10%/2) x (3/6) = Rs. 2.5