Interest rate risk for floating-rate securities, Financial Management

In a fixed-rate coupon bond, the change in the price can be attributed to the change in the market interest rates. This change is due to the difference in the prevailing market interest rate and the bond's coupon rate. But the coupon rate of a floating rate security is revised at regular intervals on the basis of the prevailing market interest rate used as the reference rate plus a quoted margin. The quoted margin is set for the life of the security. The price of a floating-rate security tends to fluctuate based on the following three factors:

  1. Greater the gap between the two reset dates, greater will be the price fluctuation.

Example 1

Consider a floating rate security whose coupon rate is reset every six months. The coupon formula is the 6-month treasury rate plus 50 basis points. Assume that on coupon-reset date, the 6-month treasury rate is equal to 6%. After a week, the 6-month treasury rate changes to 8%. This results in a decrease in the bond's price. However, if the interest rates are reset every month, the investor would realize sub-market rate only for a month and then the market interest rate would reflect in the coupon rate. Therefore, the price decline would be less.

       ii. Another reason for the price change of a floating rate security is the change in the required margin that investors demand in             the market.

Example 2

Consider a floating-rate bond X whose coupon formula is the 6-month treasury rate plus 40 basis points. In the light of the market change, investors demand 80 basis points in place of 40 basis points. Now X offers a coupon rate that is 40 basis points lesser than the market rate, thus resulting in price decline.

        iii. Generally, every floating-rate security has a cap. Once the coupon rate rises above the ceiling, then the coupon will be set               at the ceiling rate. The bond would then offer a below-market coupon rate resulting in a price decline.

In fact, once the cap is reached then there exists no difference between the floating rate coupon security and the fixed rate coupon security. Both tend to change in a similar way to the changes in market interest rates. This risk for a floating-rate security is called a cap risk.

 A sub-market rate is a coupon rate received on the floating-rate security that is less than the prevailing market interest 
     rate used as the reference rate.

Posted Date: 9/10/2012 1:04:33 AM | Location : United States

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