Floating rate note
Encyclopedia
Floating rate notes are bonds
that have a variable coupon
, equal to a money market
reference rate
, like LIBOR or federal funds rate
, plus a spread. The spread is a rate that remains constant. Almost all FRNs have quarterly coupons, i.e. they pay out interest every three months, though counter examples do exist. At the beginning of each coupon period, the coupon is calculated by taking the fixing of the reference rate
for that day and adding the spread. A typical coupon would look like 3 months USD LIBOR +0.20%.
, government sponsored enterprises (GSEs) such as the Federal Home Loan Banks
, the Federal National Mortgage Association
(Fannie Mae) and the Federal Home Loan Mortgage Corporation
(Freddie Mac) are important issuers. In Europe the main issuers are bank
s.
Perpetual FRNs are another form of FRNs that are also called irredeemable or unrated FRNs and are akin to a form of capital.
FRNs can also be obtained synthetically by the combination of a fixed rate bond
and an interest rate swap
. This combination is known as an Asset Swap.
A deleveraged floating-rate note is one bearing a coupon that is the product of the index and a leverage factor
, where the leverage factor is between zero and one. A deleveraged floater, which gives the investor decreased exposure to the underlying index, can be replicated by buying a pure FRN and entering into a swap to pay floating and receive fixed, on a notional amount of less than the face value of the FRN.
Deleveraged FRN = Long Pure FRN + Short (1 - Leverage factor) x Swap
A leveraged or super floater gives the investor increased exposure to an underlying index: the leverage factor is always greater than one. Leveraged floaters also require a floor, since the coupon rate can never be negative.
Leveraged FRN = Long Pure FRN + Long (Leverage factor - 1) x Swap + Long (Leverage factor) x Floor
. A FRN has a duration
close to zero, and its price shows very low sensitivity to changes in market rates. When market rates rise, the expected coupons of the FRN increase in line with the increase in forward rates, which means its price remains constant. Thus, FRNs differ from fixed rate bond
s, whose prices decline when market rates rise.
As FRNs are almost immune to interest rate risk, they are considered conservative investments for investors who believe market rates will increase. The risk that remains is credit risk
.
, instead of on a stock exchange
. In Europe, most FRNs are liquid, as the biggest investors are banks. In the US, FRNs are mostly held to maturity, so the markets aren't as liquid. In the wholesale markets, FRNs are typically quoted as a spread over the reference rate
.
We first compute the "effective spread"
which gives a measure of the "effective spread" over the variable coupon rate. Here the capital gain (or loss) of the FRN is taken into account, and divided over the total number of years until maturity.
The simple margin is calculated as this "effective spread" adjusted for the fact that we buy the FRN at a discount or premium to the nominal value:
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
that have a variable coupon
Coupon (bond)
A coupon payment on a bond is a periodic interest payment that the bondholder receives during the time between when the bond is issued and when it matures. Coupons are normally described in terms of the coupon rate, which is calculated by adding the total amount of coupons paid per year and...
, equal to a money market
Money market
The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...
reference rate
Reference rate
A reference rate is a rate that determines pay-offs in a financial contract and that is outside the control of the parties to the contract. It is often some form of LIBOR rate, but it can take many forms, such as a consumer price index, a house price index or an unemployment rate...
, like LIBOR or federal funds rate
Federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...
, plus a spread. The spread is a rate that remains constant. Almost all FRNs have quarterly coupons, i.e. they pay out interest every three months, though counter examples do exist. At the beginning of each coupon period, the coupon is calculated by taking the fixing of the reference rate
Reference rate
A reference rate is a rate that determines pay-offs in a financial contract and that is outside the control of the parties to the contract. It is often some form of LIBOR rate, but it can take many forms, such as a consumer price index, a house price index or an unemployment rate...
for that day and adding the spread. A typical coupon would look like 3 months USD LIBOR +0.20%.
Issuers
In the U.S.United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
, government sponsored enterprises (GSEs) such as the Federal Home Loan Banks
Federal Home Loan Banks
The Federal Home Loan Banks are 12 U.S. government-sponsored banks that provide stable, on-demand, low-cost funding to American financial institutions for home mortgage loans, small business, rural, agricultural, and economic development lending...
, the Federal National Mortgage Association
Federal National Mortgage Association
The Federal National Mortgage Association , commonly known as Fannie Mae, was founded in 1938 during the Great Depression as part of the New Deal. It is a government-sponsored enterprise , though it has been a publicly traded company since 1968...
(Fannie Mae) and the Federal Home Loan Mortgage Corporation
Federal Home Loan Mortgage Corporation
The Federal Home Loan Mortgage Corporation , known as Freddie Mac , is a public government sponsored enterprise , headquartered in the Tyson's Corner CDP in unincorporated Fairfax County, Virginia....
(Freddie Mac) are important issuers. In Europe the main issuers are bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
s.
Variations
Some FRNs have special features such as maximum or minimum coupons, called capped FRNs and floored FRNs. Those with both minimum and maximum coupons are called collared FRNs.Perpetual FRNs are another form of FRNs that are also called irredeemable or unrated FRNs and are akin to a form of capital.
FRNs can also be obtained synthetically by the combination of a fixed rate bond
Fixed rate bond
In finance, a fixed rate bond is a type of debt instrument bond with a fixed coupon rate, as opposed to a floating rate note. A fixed rate bond is a long term debt paper that carries a predetermined interest rate...
and an interest rate swap
Interest rate swap
An interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
. This combination is known as an Asset Swap.
- Perpetual Notes (PRN)
- Variable Rate Notes (VRN)
- Structured FRN
- Reverse FRN
- Capped FRN
- Floored FRN
- Collared FRN
- Step up recovery FRN (SURF)
- Range/corridor/accrual notes
- Leveraged/Deleveraged FRN
A deleveraged floating-rate note is one bearing a coupon that is the product of the index and a leverage factor
Coupon leverage
Coupon leverage, or leverage factor, is the amount by which a reference rate is multiplied to determine the floating interest rate payable by an inverse floater...
, where the leverage factor is between zero and one. A deleveraged floater, which gives the investor decreased exposure to the underlying index, can be replicated by buying a pure FRN and entering into a swap to pay floating and receive fixed, on a notional amount of less than the face value of the FRN.
Deleveraged FRN = Long Pure FRN + Short (1 - Leverage factor) x Swap
A leveraged or super floater gives the investor increased exposure to an underlying index: the leverage factor is always greater than one. Leveraged floaters also require a floor, since the coupon rate can never be negative.
Leveraged FRN = Long Pure FRN + Long (Leverage factor - 1) x Swap + Long (Leverage factor) x Floor
Risk
FRNs carry little interest rate riskInterest rate risk
Interest rate risk is the risk borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa...
. A FRN has a duration
Bond duration
In finance, the duration of a financial asset that consists of fixed cash flows, for example a bond, is the weighted average of the times until those fixed cash flows are received....
close to zero, and its price shows very low sensitivity to changes in market rates. When market rates rise, the expected coupons of the FRN increase in line with the increase in forward rates, which means its price remains constant. Thus, FRNs differ from fixed rate bond
Fixed rate bond
In finance, a fixed rate bond is a type of debt instrument bond with a fixed coupon rate, as opposed to a floating rate note. A fixed rate bond is a long term debt paper that carries a predetermined interest rate...
s, whose prices decline when market rates rise.
As FRNs are almost immune to interest rate risk, they are considered conservative investments for investors who believe market rates will increase. The risk that remains is credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
.
Trading
Securities dealers make markets in FRNs. They are traded over-the-counterOver-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
, instead of on a stock exchange
Stock exchange
A stock exchange is an entity that provides services for stock brokers and traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and redemption of securities and other financial instruments, and capital events including the payment of income and...
. In Europe, most FRNs are liquid, as the biggest investors are banks. In the US, FRNs are mostly held to maturity, so the markets aren't as liquid. In the wholesale markets, FRNs are typically quoted as a spread over the reference rate
Reference rate
A reference rate is a rate that determines pay-offs in a financial contract and that is outside the control of the parties to the contract. It is often some form of LIBOR rate, but it can take many forms, such as a consumer price index, a house price index or an unemployment rate...
.
Example
Suppose a new 5 year FRN pays a coupon of 3 months LIBOR +0.20%, and is issued at par (100.00). If the perception of the credit-worthiness of the issuer goes down, investors will demand a higher interest rate, say LIBOR +0.25%. If a trade is agreed, the price is calculated. In this example, LIBOR +0.25% would be roughly equivalent to a price of 99.75. This can be calculated as par, minus the difference between the coupon and the price that was agreed (0.05%), multiplied by the maturity (5 year).Simple margin
The simple margin is a measure of the return of a FRN.We first compute the "effective spread"
which gives a measure of the "effective spread" over the variable coupon rate. Here the capital gain (or loss) of the FRN is taken into account, and divided over the total number of years until maturity.
The simple margin is calculated as this "effective spread" adjusted for the fact that we buy the FRN at a discount or premium to the nominal value:
See also
- Inverse floating rate noteInverse floating rate noteAn inverse floating rate note, or simply an inverse floater, is a type of bond or other type of debt instrument used in finance whose coupon rate has an inverse relationship to short-term interest rates . With an inverse floater, as interest rates rise the coupon rate falls...
- Fixed rate bondFixed rate bondIn finance, a fixed rate bond is a type of debt instrument bond with a fixed coupon rate, as opposed to a floating rate note. A fixed rate bond is a long term debt paper that carries a predetermined interest rate...