Introduction to Fixed Income Analytics: Relative Value Analysis, Risk Measures, and Valuation, Second Edition

CHAPTER 6

Analysis of Floating Rate Securities

The term “floating rate security” covers several different types of securities with one common feature: the coupon rate of interest rate will vary over the instrument’s life. The rate may be based on some market interest rate (e.g., LIBOR) or a constructed interest rate (e.g., Constant Maturity Treasury rate), a noninterest rate financial benchmark or price (e.g., CPI), or it can be determined at the issuer’s discretion. Typically, floating rate securities have coupons based on a short-term money market rate or index that resets more than once a year, such as weekly, monthly, quarterly, or semiannually. Usually, the term “adjustable rate” or “variable rate” security refers to those issues with coupons based mostly on a long-term interest rate or index and reset not more than annually. In this chapter, we refer to both floating rate securities and adjustable rate securities as floating rate securities or simply floaters.

Our focus in this chapter is on the analysis of floating rate securities. In the first section, we describe the basic features of floaters. Next, we discuss the valuation of floaters without embedded options. In addition, we outline a framework of valuing floaters with embedded options. Most market participants use some “spread” measure to assess a floater’s relative value. These measures include spread for life, adjusted simple margin, adjusted total margin, discount margin, and option-adjusted spread. In the last ...