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    Floating Rate Notes: Concepts and Buzzwords

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    Myagmarsuren Sanaakhorol
    1) This document discusses floating rate notes (FRNs), which are bonds with coupons indexed to benchmark interest rates such as LIBOR. 2) FRNs are equivalent to rolling over short-term par bonds until the floater's maturity date. The coupons received from the FRN equal the coupons received from the replicating strategy of short-term par bonds. 3) The duration and convexity of a semi-annual FRN are equal to that of a 0.5-year par bond, since the FRN cash flows can be replicated by continuously rolling 0.5-year par bonds.

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    Floating Rate Notes: Concepts and Buzzwords

    Uploaded by

    Myagmarsuren Sanaakhorol
    84 views6 pages
    1) This document discusses floating rate notes (FRNs), which are bonds with coupons indexed to benchmark interest rates such as LIBOR. 2) FRNs are equivalent to rolling over short-term par bonds until the floater's maturity date. The coupons received from the FRN equal the coupons received from the replicating strategy of short-term par bonds. 3) The duration and convexity of a semi-annual FRN are equal to that of a 0.5-year par bond, since the FRN cash flows can be replicated by continuously rolling 0.5-year par bonds.

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    1) This document discusses floating rate notes (FRNs), which are bonds with coupons indexed to benchmark interest rates such as LIBOR. 2) FRNs are equivalent to rolling over short-term par bonds until the floater's maturity date. The coupons received from the FRN equal the coupons received from the replicating strategy of short-term par bonds. 3) The duration and convexity of a semi-annual FRN are equal to that of a 0.5-year par bond, since the FRN cash flows can be replicated by continuously rolling 0.5-year par bonds.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    84 views6 pages

    Floating Rate Notes: Concepts and Buzzwords

    Uploaded by

    Myagmarsuren Sanaakhorol
    1) This document discusses floating rate notes (FRNs), which are bonds with coupons indexed to benchmark interest rates such as LIBOR. 2) FRNs are equivalent to rolling over short-term par bonds until the floater's maturity date. The coupons received from the FRN equal the coupons received from the replicating strategy of short-term par bonds. 3) The duration and convexity of a semi-annual FRN are equal to that of a 0.5-year par bond, since the FRN cash flows can be replicated by continuously rolling 0.5-year par bonds.

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    © All Rights Reserved
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    Debt Instruments and Markets Professor Carpenter

    Floating Rate Notes

    Concepts and Buzzwords


    Floating Rate Notes floater, FRN, ARN,
    Cash flows VRN, benchmark
    Valuation interest rate, index
    Interest Rate Sensitivity

    Reading
    Veronesi, Chapter 1
    Tuckman, Chapter 18

    Floating Rate Notes 1


    Debt Instruments and Markets Professor Carpenter

    Introduction to Floating-Rate Notes


    A floating rate note is a bond with a coupon that is
    indexed to a benchmark interest rate.
    Possible benchmark rates include US Treasury rates,
    LIBOR, prime rate, municipal and mortgage interest
    rate indexes.
    Examples of floating-rate notes
    Corporate (especially financial institutions)
    Adjustable-rate mortgages (ARMs)
    Governments (inflation-indexed notes)

    Floating Rate Jargon


    Other terms used for floating-rate notes include
    FRNs
    Floaters and Inverse Floaters
    Variable-rate notes (VRNs)
    Adjustable-rate notes
    FRN usually refers to an instrument whose coupon
    is based on a short term rate (3-month T-bill, 6-
    month LIBOR)
    VRNs are based on longer-term rates
    (1-year T-bill, 5-year T-bond)

    Floating Rate Notes 2


    Debt Instruments and Markets Professor Carpenter

    Cash Flow Rule for Plain Vanilla Semi-


    Annual Floater
    The basic semi-annual coupon floating rate note has
    the coupon indexed to the 6-month interest rate.
    Each coupon date, the coupon is equal to the par
    value of the note times one-half the 6-month rate
    quoted 6 months earlier, at the beginning of the
    coupon period. In other words, the time t coupon
    payment as percent of par is t-0.5rt .
    The note pays par value at maturity.

    Floating Rate Note Cash Flows


    Each coupon is based on the previous 0.5-year rate.
    Only the next coupon is known at the current date. The
    later ones are random.

    0 0.5 1 ... t ... T

    Floating Rate Notes 3


    Debt Instruments and Markets Professor Carpenter

    Example: Two-Year Semi-Annual Floater


    What are the cash flows from $100 par of the note in this scenario?
    The first coupon on the bond is 100 x 0.0554/2=2.77.
    Later coupons set by the future 6-month interest rates.
    For example, suppose the future 6-month interest rates turn out as
    follows:
    0 0.5 1 1.5 2
    5.54% 6.00% 5.44% 6.18%
    Floater Cash Flows:
    0 0.5 1 1.5 2
    2.77 3.00 2.72 103.09

    100 x 0.06/2

    Replicating a T-Year Floater with


    0.5-Year Par Bonds
    Consider the following trading strategy:
    At time 0, buy a 0.5-year par bond: pay $1.
    At time 0.5, buy another 0.5-year par bond:
    collect $1+ r0.5/2, pay $1 = collect $r0.5/2
    At time 1, buy another 0.5-year par bond:
    collect $1+0.5r1/2, pay $1 = collect $0.5r1/2)
    and so on, every six months until floater maturity date T
    At time T: collect $1+T-0.5rT/2

    Floating Rate Notes 4


    Debt Instruments and Markets Professor Carpenter

    0 0.5 1 1.5 ... T

    A Semi-Annual-Coupon Floater is
    Equivalent to a 0.5-Year Par Bond
    A dynamic strategy of strategy of rolling six-month par
    bonds until floater maturity, collecting the coupons along the
    way, replicates the cash flows of a floater.
    So as semi-annual coupon floater is equivalent to the six-
    month par bond in its replicating trading strategy.
    Like its replicating trading strategy, a floater is always worth
    par on the next coupon date with certainty.
    Its coupon is set to make it worth par today.
    The duration of the floater is therefore equal to the duration
    of a six-month par bond.
    Their convexities are the same too.

    Floating Rate Notes 5


    Debt Instruments and Markets Professor Carpenter

    Class Problems
    Assume the 0.5-year rate is 5.54%.

    1) What is the duration of a semi-annual paying


    floating-rate note?

    2) What is the dollar duration of $100 par of this note?

    3) What is the convexity of this floater?

    4) What is the dollar convexity?

    Floating Rate Notes 6

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