Bond Valuation: Floating Rate Securities

Understanding Pricing of Floating Rate Securities and Inverse Floating Rate Securities

For someone new to finance, the concepts of pricing floating rate securities and their inverse counterparts might initially seem complex. However, breaking down the key components can make these concepts more accessible.

Floating Rate Securities: A Variable Interest Adventure

Imagine you lend money to a friend, but instead of receiving a fixed interest rate, your interest is tied to a dynamic benchmark, say, the interest rate prevailing in the broader market. This is similar to how floating rate securities work. These are debt instruments where the interest payments vary based on a reference interest rate, such as LIBOR or the U.S. Treasury yield.

What is LIBOR?

LIBOR, which stands for London Interbank Offered Rate, is a widely used benchmark for short-term interest rates. It represents the average interest rate at which major banks can borrow from one another in the London interbank market. LIBOR serves as a key reference rate for various financial instruments, including floating rate securities. The interest payments on these securities are often calculated as the sum of LIBOR and a fixed spread, providing investors with a variable interest rate that adjusts periodically based on market conditions.

Pricing Floating Rate Securities: The Math Behind the Variable Coupon

The process of pricing these securities involves calculating the present value of anticipated future cash flows. The coupon payments, or the interest you receive, are not fixed but are linked to the reference rate plus a predetermined spread. Here's the simplified formula:

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

Where:

• C is the coupon payment based on the reference rate.
• Spread is the fixed spread or margin over the reference rate.
• r is the required rate of return or discount rate.

Example 1: Putting Numbers into Perspective

Consider a floating rate security with LIBOR as the reference rate, a spread of 2%, and a required rate of return (r) of 5%. If the current LIBOR is 3%, the coupon payment (C) would be 3% + 2% = 5%.

Now, applying the pricing formula:

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

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

Inverse Floating Rate Securities: Riding the Waves in Reverse

Now, think of inverse floating rate securities as their mirror image. Instead of moving in tandem with the reference rate, their coupon payments move in the opposite direction.

Pricing Inverse Floating Rate Securities: A Twist in the Tale

The pricing of inverse floating rate securities follows a formula akin to that of their floating counterparts, with a small twist to account for the inverse relationship between the coupon payment and the reference rate:

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

Where:

• C is the coupon payment based on the reference rate (in inverse relationship).
• Spread is the fixed spread or margin over the reference rate.
• r is the required rate of return or discount rate.

Example 2: Navigating the Inverse Waters

Consider an inverse floating rate security tied to the U.S. Treasury yield with a spread of 1% and a required rate of return (r) of 4%. If the current Treasury yield is 3%, the coupon payment (C) would be 1% - 3% = -2%.

Using the pricing formula:

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

The negative bond price here indicates a discounted value due to the inverse relationship between the coupon payment and the reference rate.

Conclusion: Navigating the Dynamic World of Bond Pricing

In conclusion, pricing floating rate securities involves understanding the present value of future cash flows tied to variable coupon payments. In the case of inverse floating rate securities, the coupon payments move inversely to the reference rate. By applying the appropriate pricing formula, investors can evaluate the value and yields of these securities, aiding in informed investment decisions within debt and money markets. Keep in mind that actual pricing may involve additional factors such as credit risk and market conditions.

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