Floating rate coupons
FRNs typically have an interest rate cap and floor which means that the coupon rate will float between the lower value floor and upper value cap. Since the interest rate on a floating-rate note is reset periodically, its price is expected to stay close to the par value unless there is major deterioration in its credit quality or the bond hits the cap or floor.
Theoretically, the price of a floating-rate note should equal its par value at each reset date and any time before the next reset, the price equals the present value of the next coupon payment and par value. Because coupon rate is updated after each payment, it has lower interest rate risk than conventional bonds.
It is preferred by investors when they expect the interest rates to increase. However, this option of increased interest rate has a cost.
How to Price Bonds With Floating Rates | Finance - Zacks
The bond duration of a floating-rate note on the reset date equals the duration of a par bond with the same maturity as the next reset date of the FRN. The bond yield on FRNs is typically lower than the conventional fixed-rate bonds of the same maturity and credit quality.
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A more complex analysis involves working out the forward interest rates that are expected to apply to each coupon date, calculating the expected coupon amounts based on the forward interest rates inclusive of the FRN spread and then discounting those cash flows to the valuation date. This can be expressed mathematically as follows:.
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Where FV is the face value of the FRN, fr i is the forward interest rate for i th period, TF i is the time factor for the ith period represented number of days between the coupon period and valuation dated divided by , PVF i is the present value factor based on market interest rates for each coupon date and PFV n is the present value factor based on market interest rates that applies to the face value of the FRN. A more advanced may value the FRN by discounting the coupons based on spot interest rates applicable to each coupon payment. An inverse floater or an inverse FRN is a bond which is indexed to a broad interest benchmark such that its coupon payment increases when the benchmark decreases and vice versa.
If the FRN trades at par, the simple margin will equal the quoted spread.
To calculate the simple margin, first compute the sum of the quoted spread of the FRN and the capital gain or loss a investor will earn if the FRN is held to maturity:. Second, adjust the above for the fact that the FRN is bought at a discount or premium to the nominal value:.
A more complex measure of the effective spread is a discount margin , which takes into account the "time value of money" of the FRN cash flows. The formula for the calculation of the discount margin is more complex and its calculation generally requires a financial calculator or a computer. From Wikipedia, the free encyclopedia. Foreign exchange Currency Exchange rate. Forwards Options. Spot market Swaps.
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