CFA Level IFixed IncomeMedium
A 5-year floating-rate note pays a coupon equal to the 3-month reference rate plus a quoted margin of 60 basis points, resetting quarterly. An investor requires a margin of 90 basis points on bonds of comparable credit risk and liquidity. All else equal, the FRN should currently be trading at:
- APar value, because FRNs always reset to market rates
- BA discount, because reference rates are expected to rise
- CA premium, because the quoted margin exceeds the required margin
- DA discount, because the required margin exceeds the quoted margin
Show answer & explanationAnswer & explanation
Correct answer: D. A discount, because the required margin exceeds the quoted margin
When the market-required (discount) margin exceeds the quoted margin, the note's periodic coupon is insufficient compensation for its current credit/liquidity risk, so the price must fall below par to raise the effective yield to the required margin.
Why the other options are wrong
- A. FRNs reset the reference rate but the quoted margin is fixed, so price can deviate from par if risk perceptions change.
- B. Expected rate changes affect the reference rate reset, not the margin-driven premium/discount relationship.
- C. A premium would occur only if the quoted margin exceeded the required margin, the opposite of this case.
FRN Discount Margin
The spread over the reference rate that equates a floating-rate note's discounted cash flows to its market price; compared to the quoted margin to determine premium/discount pricing.
- Quoted margin = fixed spread stated at issuance
- Discount margin > quoted margin → bond priced at a discount
- Discount margin < quoted margin → bond priced at a premium
Memory trick: 'Higher required margin, lower price — risk demands a discount'