Yield spread measures for floating-rate securities, Financial Management

Assignment Help:

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.


Related Discussions:- Yield spread measures for floating-rate securities

Define the modigliani and miller theory of dividends, What is the Modiglian...

What is the Modigliani and Miller theory of dividends?  Explain. The Modigliani-Miller theory of dividends states that dividend theory is not relevant.  They state that it is the

Operating cycle , using the operating cycle and any other financial managem...

using the operating cycle and any other financial management knowledge,discuss the applicabilty of such cycle to poultry

Global bonds, These are bonds which are offered within the euro marke...

These are bonds which are offered within the euro market and several other markets simultaneously. Unlike Eurobonds, global bonds can be issued in the same curren

Opposite project - net present value, A company has the opportunity to sell...

A company has the opportunity to sell an old machine. The machine is fully depreciated to a zero book value but could be sold for $5,000. If the company did not sell the machine, i

Financial management and materials department, Financial Management and Mat...

Financial Management and Materials Department The materials management is of utmost importance in a manufacturing firm and covers the areas such as procurement, storage, mainte

Financial ratio analysis, 1. Calculate the compound average annual growth r...

1. Calculate the compound average annual growth rate in sales and profit after tax

Role of the public expenditure management system, Question : (a) The ro...

Question : (a) The role of the Public Expenditure Management System (PEMS) is to allocate and use resources responsively, efficiently and effectively'. Briefly explain the abo

Role of financial intermediaries in the financial system, Role of Financial...

Role of Financial Intermediaries in the financial system: Having designed the instrument, the issuer should then ensure that these financial assets reach the ultimate investor

Financial reports, Financial Reports: Each person has their own percept...

Financial Reports: Each person has their own perception on what a particular financial report should contain, and invariably in what they consider to be the important factors w

Personal Finance, The difference between the cost of attending a particular...

The difference between the cost of attending a particular school and the expected family contribution, minus any other financial aid.

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd