Bonds and Bond Derivatives, Second Edition

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OTHER DERIVATIVES

This chapter briefly describes some of the more common types of derivative financial instruments not covered earlier. These include floating-rate notes, interest rate swaps, convertible bonds, and preferred stock.

While many new types of securities have been introduced, only some have lasted. Lasting security types provide some significant and fundamental value to a sizable group of issuers or investors. The advantages of new instruments include one or more of the following. First, innovations may reduce transaction costs. Second, innovations may allow investors to create a new type of security which divides the cash flows from one investment into a set of derivative securities. The resulting derivatives may appeal to a new group of investors. The total value of the derivatives may be greater than the value of the underlying components. An example is the decomposition of Treasury bonds into Treasury strips. Third, new instruments (e.g., options) may allow the transfer or limiting of risks. Fourth, some products (e.g., futures contracts) allow investors to diversify more efficiently. Fifth, some new financial instruments are responses to changes in tax laws and regulations.

Floating-Rate Notes

A floating-rate note is a bond with a variable interest rate. The coupon on the floating-rate note is tied to a particular short-term interest rate. Periodically, perhaps every 6 months, the coupon on the bond is reset to equal the short-term rate plus X percent.

As an ...