Yield spread measures for floating-rate securities, Financial Management

In a floating rate security, the coupon rate changes periodically as per the reference rate. The yield to maturity of floating rate securities cannot be calculated as the future value of the reference rates which determine the cash flows are unknown. Instead, conventional measures like spread for life, adjusted simple margin, adjusted total margin, and discount margin are used. Of these, the discount margin measure is more popular. The method for calculating discount margin is given below:

  1. First, cash flows are determined assuming that the reference rate does not change over the entire life of the floating rate security.

  2. Next, a margin is to be selected.

  3. Then, the cash flows found in step 1 are discounted using the current value of the reference rate plus the margin selected in step 2.

  4. The present value calculated in step 3 is then compared to the price plus accrued interest. If it is equal then the margin selected is the discount. If not, the process needs to be repeated with a different margin.

Let us illustrate this with an example.

Assume that the coupon reset formula for a Rs.100 par value, 4-year floating-rate security selling at Rs.98.4991 is the 6 month MIBOR plus 50 basis points. The interest rate is reset after every 6 months. The current MIBOR is 7.50%.

Table : Calculation of Discount Margin for a Floating-Rate Security

2180_yield measure for floating rate security.png

Cash flow for the period 1 to 7 is semiannual interest rate and for 8th period it is semiannual interest rate plus par value of the security.

   Annual Rate = MIBOR + Basis Points

   Semiannual rate = Annual rate / 2

   PV at assumed margin = Cash flow / (1 + Semiannual rate) time period

Discount margin as a measure of the returns form the floating rate security assumes that the reference rate will not change over the life of the security and it also does not take into consideration the cap and floor of the floating-rate securities. These are the two main drawbacks of this measure.

Posted Date: 9/10/2012 2:05:11 AM | Location : United States







Related Discussions:- Yield spread measures for floating-rate securities, Assignment Help, Ask Question on Yield spread measures for floating-rate securities, Get Answer, Expert's Help, Yield spread measures for floating-rate securities Discussions

Write discussion on Yield spread measures for floating-rate securities
Your posts are moderated
Related Questions
a Suppose you are the TA of Econ 3602 and one student does not know how to derive the DD schedule. Show this student how to derive the DD schedule. Support your answer with equatio

1) According to the IFE (RIP), if U.S. investors expect a 3% rate of domestic inflation over one year, and a 6% rate of inflation in European countries that use the EUR, and requir

AOT limited is considering two mutually exclusive projects - cable and satellite.  The possible NPVs for every project and their associated probabilities are as follows: Cable:

DEFINITION OF FINANCIAL MANAGEMENT The term financial management has been described by management experts in several ways reflecting the duties and responsibilities of a financ

Explain the term- Market penetration A strategy which pursues to increase sales of existing services or products to the same market. Price reduction strategies Aggre

Why do a Split? A 4 x 1 Split is an operation by which a shareholder now owns 4 shares for every share he/she had before. Logically, the stock market value of each of these new

Who owns a credit union? Explain. The term Credit unions are owned by their members. While credit union members put money in their credit union, they are not exactly "depositin

Table 1:  Politics Stability of the existing government structure National/provincial government r

Determine the example of Rate of return of a Bond A bond is paying 10 % interest per annum and is going to mature in next two years At maturity it would pay its principal amoun