- Floating rate note
Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a
money market reference rate, like LIBORor federal funds rate, plus a spread. The spread is a rate that remains constant. Almost all FRNs have quarterly coupons, i.e. they pay out interest every three months, though counter examples do exist. At the beginning of each coupon period, the coupon is calculated by taking the fixing of the reference ratefor that day and adding the spread. A typical coupon would look like 3 months USD LIBOR +0.20%.
In the U.S.,
government sponsored enterprises (GSEs) such as the Federal Home Loan Banks, the Federal National Mortgage Association(Fannie Mae) and the Federal Home Loan Mortgage Corporation(Freddie Mac) are important issuers. In Europe the main issuers are banks.
Some FRNs have special features such as maximum or minimum coupons, called capped FRNs and floored FRNs. Those with both minimum and maximum coupons are called collared FRNs.
FRNs can also be obtained synthetically by the combination of a
fixed rate bondand an interest rate swap. This combination is known as an Asset Swap.
FRNs carry little
interest rate risk. An FRN has a duration close to zero, and its price shows very low sensitivity to changes in market rates. When market rates rise, the expected coupons of the FRN increase in line with the increase in forward rates, which means its price remains constant. Thus, FRNs differ from fixed rate bonds, whose prices decline when market rates rise.
As FRNs are almost immune to interest rate risk, they are considered conservative investments for investors who believe market rates will increase. The risk that remains is
Securities dealers make markets in FRNs. They are traded over-the-counter, instead of on a
stock exchange. In Europe, most FRNs are liquid, as the biggest investors are banks. In the US, FRNs are mostly held to maturity, so the markets aren't as liquid. In the wholesale markets, FRNs are typically quoted as a spread over the reference rate.
Suppose a new 5 year FRN pays a coupon of 3 months LIBOR +0.20%, and is issued at par (100.00). If the perception of the credit-worthiness of the issuer goes down, investors will demand a higher interest rate, say LIBOR +0.25%. Therefore, a dealer would then make a market of 27 / 25. This means, that he would buy bonds at the equivalent of LIBOR +0.27%, and sell at the equivalent of LIBOR +0.25%. If a trade is agreed, the price is calculated. In this example, LIBOR +0.27% would be roughly equivalent to a price of 99.65. This can be calculated as par, minus the difference between the coupon and the price that was agreed (0.07%), multiplied by the maturity (5 year).
Inverse floating rate note
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