Floating-Rate Note

An FRN's life is divided into reset periods. At the start of each period the reference rate is observed and fixed; the coupon paid at the end of that period equals the observed reference rate plus the quoted margin, multiplied by the period fraction and the par amount. A note paying quarterly with a reference rate of 4.20% and a quoted margin of 80 basis points would pay 5.00% annualised for that quarter, or roughly one quarter of that amount in cash. The reference rate is therefore known in advance of payment but unknown for all later periods, which is why valuation requires an assumption about future rate levels.

Structural features modify this basic pattern. A cap limits the maximum coupon, benefiting the issuer; a floor limits the minimum, benefiting the investor. Many post-2021 SOFR notes use a compounded average of daily overnight rates over the period rather than a single fixed-in-advance observation, so the coupon is determined in arrears. Inverse floaters pay a fixed rate minus a multiple of the reference rate, and move in the opposite direction to short-term yields.

The key comparison is between the quoted margin written into the contract and the margin the market currently demands for that issuer's credit quality and liquidity, the required margin. If the two are equal, the note prices at par on each reset date. If credit quality deteriorates so the required margin rises above the quoted margin, the note trades at a discount; if the issuer's spread narrows, it trades at a premium. Price therefore reflects spread changes, not the level of short-term rates.

The conventional yield measure is the discount margin: the constant spread that, when added to the assumed path of the reference rate and used to discount projected coupons and principal, makes the present value equal the observed price. At Level I the projection is usually simplified by holding the current reference rate constant for all remaining periods, so the calculation reduces to a standard bond pricing exercise in which the discount rate equals the current reference rate plus the unknown margin. Solving for that margin, then comparing it with the quoted margin, tells you immediately whether the note is at a premium or a discount.

Floating-rate structures dominate segments where the lender's own funding cost is short-dated. Banks issue floaters to match rate-sensitive liabilities; investment-grade and high-yield corporates issue them to broaden the buyer base when investors expect rising policy rates. Broadly syndicated leveraged loans are effectively floaters with a base rate plus a credit spread and, very commonly, a base-rate floor. Most asset-backed and mortgage-backed tranches pass through a floating coupon to senior investors, and money market and short-duration funds are natural holders because a floater's price stability suits a stable net asset value mandate.

On the risk side, the reset mechanism compresses the note's sensitivity to the level of interest rates: effective duration is roughly the time remaining to the next reset, typically a fraction of a year. Spread duration, however, reflects the full remaining maturity, so a five-year floater can lose meaningful value if the issuer's credit spread widens. This asymmetry is the central analytical point about the instrument.

Exam tasks cluster into four groups. First, construct a coupon: given a reference rate observation, quoted margin, day count and payment frequency, compute the cash payment for a stated period. Second, reason about price direction: state whether a note trades above, at or below par once you know how the required margin compares with the quoted margin, and explain the credit or liquidity change behind it. Third, compute a price from a given discount margin, or back out the discount margin from a given price, using the simplifying assumption that the current reference rate persists.

Fourth, describe risk exposures precisely. Be ready to distinguish the small residual rate sensitivity between resets from the full-maturity spread sensitivity, to explain how caps and floors reintroduce rate risk once they bind, and to identify how a reference-rate transition, such as the move from an interbank offered rate to an overnight risk-free rate with a spread adjustment, changes the economics of an existing note without changing its structural form.