Fixed Income and Credit Risk jh Prof. Michael Rockinger on oN B - 4 - Floating Rate Notes mite leat \ — ote * i - "Floaters ads t Jee ww? aw e—l ad on OCoF Bat Nac dn lee sot hye ae SveaLearning Objectives @ Be able to explain what a FRN is @ Obtain the price of a FRN at reset dates @ Obtain the price of a FRN at non-reset dates 2Floating Rate Notes (PV52') @ Floating Rate Notes (FRN) nickname floaters are bond-type financial instruments: there is a time varying coupon which gets regularly rest. Bond may expire after many years. Coupon depends on a reference rate, say r,(T;-1, 7;) which will be reset at time 7;_; and paid at time 7;. The times 7;_) are called reset dates. Which leads to lingo such as: the interest rate has been ‘resetted’. e@ Assume 7; = 7;-; + A, thus, times are regularly spaced, A = 1/n @ Time runs from t = 0 via 7; for i= 1,--- ,m so that at time 7, the FRN ends ‘There is a change of notation in Veronesi’s book which renders understanding more complicated. Better stick to my stuff 3/8Rin Ie in fe Reo ch, oor vavalion of an FRN_ a aka Pe tir mb ‘um vel. at Attime 7... the rate ry(T;-1, 7) is hee © ew) CC ————e— Cie en vo. mt * wah 19 God Mm \ oe a Sae6n gry iS \ v Di rs sen] i) where gis an | ph prea © Attime 7; the coupon rate will be cr, annualized spread. ‘© A firm which is subject to default risk may wish to pay to its creditors a rate which is above the (reference r,) interbank rate. The spread s reflects this compensation. 48Floating Rate Notes: Pricing @ Notice that the payments over time can be split into a variable part and a constant-over-time part @ At the payment date 7; the payment is Cc ri(Ti-1,T))N + AsN @ The value, at ¢ = 0, of the constant part As J is trivial to obtain, it is an annuity @}) Hence, let us focus on the variable partl How can we discount this — SSS part? 5/8ke Vahe Bord of 122 2@-—— Lewes 4 Simone © ja NS MV Topey TS ey tS Tha i) oT ae t rp ? Lv + Coe ND Far M4 Value border t=? ° Touts) _ iB ND Gal Tons Tom ) = (aw Volue 4 fred heg” noe[zlein sae 210, Tm) + Am (rok vlna fook “4: Found vie ached indus Too yaw Cet a L. [Pes Ton uo — Ty ilh ebrlen + Find 2 volw. q Wat MVOC ( Tana, Tom ) ah wah dt, iy potales tL ft ‘ ot too Velev N “a tn T eo bile nina wl, < NAc Xu (Tony, Pa) 2 [Tea To) saeFloating Rate Notes: Pricing of the variable part @ The value of the variable part is found by starting from the end (backward induction) @ At the terminal payment date 7, the payment is ArnTin-1sTm)N +N = (1+ ArnTn-1, Tm) N- @ At time T,,_; the value of the variable part of the bond is ZT ns Tm) + AFn(Tin-15 Tm) N e@ But 1 1+ Arn(Tn-1, Tm) @ and so the value of the variable part at time 7,,-; is: ZEm-15 Tm) = U1 + AraTin-1, Tm) N =N. 1+ Arn(Tn-1,Tm) 6/8Floating Rate Notes: Pricing of the whole thing at ¢ = 0 @ One iterates happily backwards to obtain that at ¢ = 0 the value of the variable part is N @ Put things together... @ The value, at t = 0 of the fixed part is simply > 45NZ0,7) i=l @ And, so the total value of the FRN at ¢ = 0 is simply: N+) AsNZO,T) i=l 718Value ok ome induc dd Ticba Te Ve pig inbumd ch Mee - — Me ener r - 0 io Laat Tf To fe me , \ Belge? BATT 0k rent Cth pant ~ —— — are wl 2tisn) + 21+, f) ; Feo oat9 Bat, quedion La a Bene = 2(6 =) LO of Hur Kiown S W)+ v0 (Ts 1) Hr vale of 3 il ted vulS 7): 247) fubrey Z{ Qe vp Aten Dive the Uo ee ype. | G God pre te cen agmivdt fete .Floating Rate Notes: Pricing of the whole thing at t # 0 @ Suppose the FRN has already lived till time ¢ with Tj) <¢ < T; @ The value, at r of the fixed part is simply m > Asn 20,7) =i @ For the variable part, recognize that the spot interest rate between T;-; and T; has been set already @ Hence, the value, at ¢ of this part is Zt, TU + AraTi-1, TN @ And, so the total value of the FRN at r is ZT) + Arg(T-1,T)N + Asn ze, T)) j=l 8/8