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
Central Bank : The Central Bank is the nation's principal monetary authority responsible for the monetary policy of the country. It regulates money supply and credit, issues cur

Financial Ratios: Another method of measuring and monitoring performance is through the use of financial ratios and other comparative tools. Financial ratios use information

• Sales revenue line drawn and labelled correctly and accurately • Fixed cost line (at $1,020) labelled and drawn accurately and correctly • Total costs line (starting at $1,

Question: Part A  The financial system is complex in structure and function throughout the world. There are many different types of institutions: banks, insurance compani

Debt holders versus Shareholders A second agency problem arises because of potential conflict between stockholders and creditors. Creditors lend finances to the firm at rates w

LKL PLC Project VZ (a) Cash Flow budget and NPV WORKINGS

Commercial Paper (CP) is a short-term unsecured promissory note issued in the open market. It also represents the obligation of the issuer. Normally, it is issued

Once capital markets are integrated, it is hard for a country to maintain a fixed exchange rate. Explain why this may be so. Answer: one time capital markets are integrated int

Types of Financial Assets Majority of financial assets used worldwide are in the form of deposits, stocks and debt. Deposits Deposits can be made either with banking or

What is Inventory turnover The shortcoming of this ratio is that average calculation based on beginning and year-end inventory may not represent actual average in year. Other l