4 - Floating-rate notes

Abstract

Floating-rate notes (FRNs) or floaters are among the simplest debt instruments. They are essentially bonds with a time-varying coupon. This chapter describes the basics of FRNs and introduces some notations and concepts related to the same. FRNs are not credit derivatives, but they are featured prominently, such as credit default swaps, asset swaps, and spread options. The main reason for the close link between FRNs and credit derivatives is that the pricing of a floater is almost entirely determined by market participants' perceptions of the credit risk associated with its issuer. As such, floaters are potentially closer to credit default swaps than to fixed-rate corporate notes, which, as the name suggests, are bonds with a fixed coupon. The variable coupon on a floating-rate note is typically expressed as a fixed spread over a benchmark short-term interest rate, most commonly three or six-month London Interbank Offered Rate (LIBOR). LIBOR is the rate at which highly rated commercial banks can borrow in the interbank market. From the credit investor's standpoint, FRNs have one key advantage over their fixed-rate cousins. The value of a portfolio of floaters depends almost exclusively on the perceived credit quality of their issuers represented in the portfolio. Thus, similar to someone who has sold protection in a credit default swap, the FRN investor has primarily bought some exposure to credit risk.