10 - Pricing and hedging non-fixed income securities

Abstract

This chapter presents a discussion on pricing and hedging nonfixed income securities. The chapter examines structured securities—such as floaters, inverse floaters, and interest rate swaps—and interest rate derivatives—such as caps, floors, and collars. A floater is the simplest form of the structured security. A floater is an ordinary fixed income security except that its income is not fixed. Just like ordinary bonds, floaters pay coupons periodically—annually, semi-annually, or quarterly are common payment structures. A floater is priced in terms of $100 and at maturity it returns the last coupon payment and the final redemption amount. In other words, the basic structure of the financial contract is precisely the same as an ordinary bond except that the coupon rate will be adjusted or reset periodically. The coupon rate of a floater varies directly with some “reference” rate—that is, as the libor rate increases, the floating rate coupon increases. The coupon is reset annually, semi-annually, or quarterly according to some defined relationship with the reference rate.