READING 54 YIELD AND YIELD SPREAD MEASURES FOR FLOATING-RATE INSTRUMENTS Flashcards
(13 cards)
Which of the following best explains why floating-rate notes (FRNs) tend to have more stable values than fixed-rate bonds of similar maturity?
A. FRNs pay coupons based on a fixed rate plus a variable margin, reducing interest rate risk.
B. FRN coupon rates reset periodically based on a market reference rate, adjusting for changes in interest rates.
C. FRNs have longer maturities that smooth out price fluctuations over time.
Correct Answer: B
Explanation:
The coupon on FRNs is reset periodically based on a variable market reference rate (MRR), which means the coupon adjusts with interest rates, stabilizing the bond’s value.
A is incorrect because the margin is fixed, not variable; the MRR is variable.
C is incorrect because maturity length does not directly explain stability in price.
The coupon rate on an FRN consists of:
A. A fixed margin plus a market reference rate (MRR) that resets periodically.
B. A fixed coupon rate determined at issuance with no adjustments.
C. A floating margin that varies with issuer credit risk plus a fixed MRR.
Correct Answer: A
Explanation:
The coupon equals the current MRR plus a fixed margin reflecting issuer credit risk at issuance.
B is incorrect because FRNs do not have fixed coupons.
C is incorrect because the margin is fixed, not floating.
Why is interest on FRNs said to be “paid in arrears”?
A. Because the interest payment occurs before the coupon rate is set.
B. Because the coupon rate is set at the beginning of the period but paid at the end.
C. Because the interest is delayed beyond the scheduled payment date.
Correct Answer: B
Explanation:
The coupon rate for the period is set at the start using the current MRR but the actual interest payment happens at the end of the period, so interest is paid “after the fact.”
A is incorrect as the payment does not happen before rate setting.
C is incorrect because there is no unusual delay.
If the issuer of an FRN has higher credit risk than the financial institutions underlying the MRR, what happens to the margin?
A. A margin is subtracted from the MRR.
B. A margin is added to the MRR.
C. The margin remains unchanged regardless of credit risk.
Correct Answer: B
Explanation:
Higher credit risk requires an added margin over the MRR to compensate investors.
A is incorrect because less credit risk would lead to subtracting a margin.
C is incorrect because the margin depends on credit risk.
What is the Quoted Margin (QM) on an FRN?
A. The margin required to price the FRN at par.
B. The fixed margin over the MRR actually paid in the coupon.
C. The margin that changes with market liquidity conditions.
Correct Answer: B
Explanation:
QM is the fixed margin set at issuance and included in coupon payments.
A is incorrect because that describes the Discount Margin (DM).
C is incorrect because the QM is fixed, not variable.
What does the Discount Margin (DM) represent for an FRN?
A. The fixed margin set at issuance.
B. The margin investors require for the bond to trade at par given current credit risk.
C. The margin that fluctuates with the market reference rate.
Correct Answer: B
Explanation:
DM reflects the margin necessary so the FRN’s price equals par, adjusting for credit risk changes.
A is incorrect because QM is fixed, not DM.
C is incorrect because DM is related to credit risk, not MRR.
If an FRN’s issuer credit quality declines after issuance, what is the expected effect on the FRN’s price?
A. The FRN will trade at a premium to par.
B. The FRN will trade at a discount to par.
C. The FRN price will remain at par.
Correct Answer: B
Explanation:
Declining credit quality increases required DM above QM, causing the FRN to trade below par.
A is incorrect since improved credit quality causes premium pricing.
C is incorrect unless credit quality remains unchanged.
Which scenario would cause an FRN to trade at a premium?
A. The QM is less than the DM.
B. The issuer’s credit rating improves during the life of the FRN.
C. The MRR decreases sharply but the QM remains fixed.
Correct Answer: B
Explanation:
Improved credit quality reduces DM below QM, making the bond trade at a premium.
A is incorrect; if QM < DM, bond trades at a discount.
C affects coupon payments but does not necessarily cause premium pricing.
Which statement correctly compares the coupon and yield on an FRN when it trades below par?
A. MRR + DM is less than MRR + QM.
B. MRR + DM is equal to MRR + QM.
C. MRR + DM is greater than MRR + QM.
Correct Answer: C
Explanation:
Investors require a higher yield (MRR + DM) than the coupon paid (MRR + QM), indicating a deficiency and discount price.
A is incorrect because that implies premium pricing.
B is incorrect because that implies trading at par.
A simplified valuation approach for an FRN on a reset date involves:
A. Using the current MRR plus DM to estimate coupon payments and discounting at MRR plus QM.
B. Using the current MRR plus QM to estimate coupon payments and discounting at MRR plus DM.
C. Using fixed coupons to estimate cash flows discounted at MRR plus QM.
Correct Answer: B
Explanation:
The coupon payments are estimated with current MRR + QM and discounted at MRR + DM.
A reverses the discounting and coupon estimation.
C is incorrect because coupons vary with MRR.
If the present value (PV) of an FRN is calculated as 98.67% of its face value, this indicates that:
A. The FRN is trading at a premium.
B. The FRN is trading at par.
C. The FRN is trading at a discount.
Correct Answer: C
Explanation:
PV below 100% means the bond trades at a discount.
A is incorrect as premium means PV > 100%.
B means PV = 100%.
Which factor does NOT affect the fixed margin (QM) on an FRN at issuance?
A. Issuer’s credit risk relative to the MRR.
B. Liquidity of the FRN.
C. Future changes in the market reference rate (MRR).
Correct Answer: C
Explanation:
QM is fixed at issuance and based on credit risk and liquidity, not future MRR changes.
A and B both affect QM at issuance.
Why might more complex models be preferred over the simplified valuation method for FRNs?
A. They better account for changes in credit risk and interest rates over time.
B. They require fewer inputs, making calculations faster.
C. They ignore the discount margin and focus only on the quoted margin.
Correct Answer: A
Explanation:
Complex models can dynamically model credit and interest rate changes for more accurate valuation.
B is false; complex models require more inputs.
C is false; ignoring DM would reduce accuracy.
