Bond Valuation: Floating Rate Securities

Pricing Floating Rate Securities and Inverse Floating Rate Securities

Floating rate securities are debt instruments whose coupon payments are tied to a reference interest rate, such as LIBOR or the U.S. Treasury yield. These securities provide investors with a variable interest rate that adjusts periodically, typically based on a predetermined spread or margin over the reference rate. Understanding the process of pricing floating rate securities, as well as their inverse counterparts, is crucial for evaluating their value, assessing yields, and making informed investment decisions in debt and money markets.

Pricing Floating Rate Securities

The pricing of floating rate securities involves calculating the present value of expected future cash flows, which comprise the variable coupon payments based on the reference rate. The pricing formula for floating rate securities is as follows:

Bond Price = C * (1 + Spread) / (1 + r)

Where:
C = Coupon payment based on the reference rate
Spread = Fixed spread or margin over the reference rate
r = Required rate of return or discount rate

Example 1:
Let's consider a floating rate security with the following characteristics:
Reference rate = LIBOR
Spread = 2%
Required rate of return (r) = 5%

Assuming the reference rate (LIBOR) is currently at 3%, the coupon payment (C) would be calculated as follows:

Coupon payment (C) = LIBOR + Spread
C = 3% + 2%
C = 5%

Using the pricing formula, we can calculate the price of this floating rate security:

Bond Price = 5% * (1 + 0.02) / (1 + 0.05)
Bond Price ≈ 4.76

Hence, the price of this floating rate security would be approximately 4.76.

Pricing Inverse Floating Rate Securities:
Inverse floating rate securities, also known as reverse floating rate securities, have coupon payments that move in the opposite direction of the reference interest rate. The pricing of inverse floating rate securities is similar to floating rate securities, but with an adjustment to account for the inverse relationship between the coupon payment and the reference rate. The pricing formula for inverse floating rate securities is as follows:

Bond Price = C * (1 - Spread) / (1 + r)

Where:
C = Coupon payment based on the reference rate (in inverse relationship)
Spread = Fixed spread or margin over the reference rate
r = Required rate of return or discount rate

Example 2:
Let's consider an inverse floating rate security with the following characteristics:
Reference rate = U.S. Treasury yield
Spread = 1%
Required rate of return (r) = 4%

Assuming the U.S. Treasury yield is currently at 3%, the coupon payment (C) for the inverse floating rate security would be calculated as follows:

Coupon payment (C) = 1% - Treasury yield
C = 1% - 3%
C = -2%

Using the pricing formula, we can calculate the price of this inverse floating rate security:

Bond Price = -2% * (1 - 0.01) / (1 + 0.04)
Bond Price ≈ -1.92

In this case, the negative bond price indicates a discounted value due to the inverse relationship between the coupon payment and the reference rate.

Conclusion

Pricing floating rate securities involves calculating the present value of expected future cash flows based on variable coupon payments tied to a reference rate. In the case of inverse floating rate securities, the coupon payments move in the opposite direction of the reference rate. By applying the appropriate pricing formula, investors can evaluate the value and yields of these securities, enabling informed investment decisions in debt and money markets. It's important to note that the actual pricing of floating rate securities may incorporate additional factors, such as credit risk, market conditions, and the terms and conditions specific to each security.

This article takes inspiration from a lesson found in FIN 4243 at the University of Florida.