Practice: Yield and Yield Spread Measures for Floating-Rate Instruments
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Fixed IncomeYield and Yield Spread Measures for Floating-Rate Instruments
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Question 1Exam level
A floating rate note pays a quarterly coupon equal to 3-month SOFR plus 120 basis points. At the most recent reset date, 3-month SOFR was 4.80%. The annualized coupon rate for the next period is closest to:
How sure are you?
Correct: A. The correct answer is 6.00%. FRN coupon = Reference Rate + Quoted Margin = 4.80% + 1.20% = 6.00%. The coupon rate is set at each reset date based on the then-current reference rate plus the fixed spread. Always add both components; never use either alone..
B. The quoted margin is 120 bps = 1.20%, and candidates remember 'the spread' as the key FRN parameter. The 1.20% is only the spread above the reference rate, not the total coupon. The coupon always equals the full reference rate plus the spread.
C. The reference rate (SOFR 4.80%) is the dominant component and candidates may recall SOFR as 'the FRN rate.'. 4.80% is only the reference rate floor; the investor earns SOFR plus the quoted margin. The spread compensates for issuer credit risk above the risk-free rate.
An investor holds a floating rate note with a quarterly reset tied to 3-month SOFR. Immediately after a coupon reset date, market interest rates rise by 200 basis points. The FRN's price will most likely:
How sure are you?
Correct: A. The correct answer is Remain close to par value. FRNs reset their coupon periodically to market rates, giving them very low interest rate duration (approximately equal to the reset period, not the maturity). The rate rise will be captured in the next quarterly reset, so price stays near par..
B. A 200 bps rate rise would cause a long fixed-rate bond to fall substantially in price, and candidates applying bond price/yield mechanics without adjusting for the reset feature. This describes a fixed-rate bond. An FRN's coupon adjusts at the next reset, so the price impact of a rate change is limited to the short period until the next reset date. Not the full maturity.
C. You might reason that higher SOFR means higher future coupons, so the bond must be worth more. The bond is priced on its CURRENT period's coupon (already set at reset) plus present value of future cash flows, which also reset up. The net effect is near-zero price change, not a rise above par.
A TIPS bond has a par value of $1,000 and a real coupon rate of 1.50% paid semiannually. The CPI index ratio at the end of year 1 is 1.04 (CPI has risen 4% since issuance). The coupon payment at the end of year 1 (second semiannual period) is closest to:
How sure are you?
Correct: A. The correct answer is $7.80. Step 1: Inflation-adjusted principal = $1,000 × 1.04 = $1,040. Step 2: Semiannual coupon = $1,040 × (1.50% / 2) = $1,040 × 0.0075 = $7.80. The real coupon rate is fixed but applies to the inflation-adjusted principal, not original par..
B. Applying the coupon rate directly to original par ($1,000 × 0.0075 = $7.50) is the natural instinct from fixed-rate bond training. Step 1 (adjust principal) is skipped under time pressure. This ignores the core TIPS mechanism: the principal is adjusted upward with inflation before the coupon is calculated. Skipping principal adjustment is the single most common TIPS calculation error.
C. You might may compute the annual coupon ($1,040 × 1.50% = $15.60 rounded to $15.00) and forget to halve it for semiannual frequency. The question asks for a semiannual payment. The annual coupon must be divided by 2. This trap catches candidates who correctly adjust the principal but miss the frequency halving.
At maturity, a TIPS bond has an inflation-adjusted principal of $880 due to sustained deflation over the bond's life. The bond's stated par value at issuance was $1,000. The investor at maturity receives, most likely:
How sure are you?
Correct: A. The correct answer is $1,000, the original par value. TIPS have a deflation floor: at maturity the U.S. Treasury pays the GREATER of the inflation-adjusted principal or the original par value. max($880, $1,000) = $1,000. This is an explicit government guarantee embedded in TIPS structure..
B. Mechanically applying the inflation-adjustment formula in reverse without knowing the deflation floor. If inflation lowers the principal, candidates assume that is what is paid. The deflation floor overrides the formula at maturity. The U.S. Treasury guarantees the investor cannot receive less than original par at maturity. This is a statutory TIPS feature, not optional.
C. Candidates who know the deflation floor protects the investor may overcorrect and think there is an additional payment to compensate for the deflation period. There is no additional payment. The investor simply receives the original par value ($1,000). No penalty, no extra compensation, just par.
A floating rate note's quoted margin is 150 bps. If the market now requires a spread of 200 bps over the reference rate due to credit deterioration since issuance, the FRN will most likely trade:
How sure are you?
Correct: A. The correct answer is Below par. Required Margin (200 bps) > Quoted Margin (150 bps), meaning the FRN's coupon is 50 bps per period less than what investors require. The price must fall below par so the total yield (coupon + price appreciation to par) equals the required 200 bps. This is entirely a credit signal, not an interest rate signal..
B. You might confuse 'fixed spread' with 'advantageous yield.' If the coupon is set at a fixed 150 bps spread, they may think the bond is somehow more valuable than a bond paying less. The 150 bps spread is below what the market now requires (200 bps). A below-market coupon forces the price below par. Not above it.
C. The rule 'FRNs trade at par at reset dates' is overlearned and candidates apply it as an absolute truth without the critical caveat. FRNs trade at par only when Quoted Margin = Required Margin at the reset date. Credit deterioration breaks this condition. The reset mechanism handles interest rate risk only. It does nothing for credit risk.
The breakeven inflation rate implied by the market is most likely described as:
How sure are you?
Correct: A. The correct answer is The nominal yield on a comparable-maturity Treasury minus the real yield on a TIPS. Derived from the Fisher approximation: nominal ≈ real + inflation, rearranged to breakeven inflation = nominal − real. This is the inflation rate at which TIPS and nominal Treasuries deliver the same total return..
B. The word 'breakeven' combined with 'inflation' makes candidates reach for the current CPI figure they've seen in the news. Breakeven inflation is a forward-looking MARKET PRICE derived from bond yields, not a backward-looking economic statistic. Current CPI is observed data; breakeven is a yield spread.
C. You might confuse coupon rates with yields. If TIPS coupons are lower (they are real, not nominal), subtracting coupon rates might seem analogous. Breakeven is a YIELD comparison, not a coupon comparison. TIPS coupon rates are set at a fixed real rate; the inflation compensation comes through principal adjustment, not a higher coupon.
An FRN has a cap of 6.00% and a floor of 2.00%. The reference rate rises to 7.00% and the quoted spread is 50 bps. The actual coupon rate paid this period is closest to:
How sure are you?
Correct: A. The correct answer is 6.00%. The formula gives: reference rate + spread = 7.00% + 0.50% = 7.50%, but the cap limits the maximum coupon to 6.00%. The cap is an embedded interest rate cap purchased by the issuer, which limits maximum coupon payment. The floor (2.00%) would protect the investor if rates fell very low. It is irrelevant here..
B. Directly applying the FRN formula (reference + spread = 7.50%) without remembering the cap override. The cap of 6.00% overrides the formula output. Any time the computed coupon exceeds the cap, the cap binds and the actual coupon is the cap rate.
C. You might notice the floor value and assume the floor is the binding constraint here. The floor (2.00%) only binds when the reference rate + spread would otherwise fall below 2.00%. Here the rate is very high (7.50% uncapped), so only the cap is relevant.
Compared to a fixed-rate bond with the same maturity and credit quality issued by the same company, a floating rate note will most likely have:
How sure are you?
Correct: A. The correct answer is Lower interest rate risk and the same credit risk. The periodic coupon reset neutralizes interest rate risk (duration ≈ reset period, not maturity). However, credit risk is identical: both bonds are obligations of the same issuer, equally exposed to default. The reset mechanism only hedges rate risk..
B. You might confuse the two risk dimensions. The word 'floating' suggests volatility, leading to the wrong inference of 'higher risk.'. This exactly reverses the truth. FRNs have LOWER (not higher) interest rate risk and the SAME (not lower) credit risk.
C. Overgeneralization of the 'FRNs eliminate risk' heuristic. You might correctly know FRNs hedge rate risk and incorrectly extend this to all risks. FRNs still carry full credit risk from the issuer. Additionally they retain residual interest rate risk between reset dates. 'No risk of any kind' is never the correct answer for a corporate FRN.
A TIPS bond has a real yield of 1.80% and a comparable nominal 10-year Treasury yields 4.20%. An investor expecting annual inflation of 3.00% over the next 10 years should most likely:
How sure are you?
Correct: A. The correct answer is Buy TIPS. Breakeven inflation = 4.20% − 1.80% = 2.40%. The investor expects 3.00% > 2.40% breakeven. When realized inflation exceeds breakeven, TIPS outperform nominal Treasuries. The TIPS principal will be adjusted upward by more than the market had priced in, generating superior total return..
B. Candidates who compute the breakeven (2.40%) but get the decision direction backwards. They see 3.00% > 2.40% but incorrectly conclude nominal wins when inflation is 'above' the breakeven. Nominal beats TIPS only when actual inflation falls BELOW the breakeven. Here 3.00% > 2.40%. TIPS wins. Higher-than-breakeven inflation = TIPS outperforms.
C. You might misapply the breakeven concept. Breakeven means 'equal return at exactly this inflation rate,' and they extend this to 'always equal.'. TIPS and nominal only deliver equal total return when realized inflation equals the breakeven exactly. At any other inflation level, one instrument outperforms. Here, 3.00% ≠ 2.40%, so they are not indifferent.
An FRN resets its coupon every 180 days based on 6-month SOFR. A bond analyst states the FRN's Macaulay duration equals its time to maturity of 5 years. This statement is most likely:
How sure are you?
Correct: A. The correct answer is Incorrect. For an FRN, the effective interest rate duration is approximately equal to the coupon reset period (180 days = 0.50 years), not the time to maturity. At each reset date the bond reprices to par, so it behaves like a new 180-day instrument from a market risk perspective. The 5-year time to maturity tells you when principal is returned, but says nothing about interest rate sensitivity..
B. You might apply fixed-rate bond duration mechanics: for a fixed bond, longer maturity generally means longer duration. They mistakenly transfer this to FRNs. The duration calculation for FRNs is fundamentally different from fixed-rate bonds. The reset mechanism makes the duration approximately equal to the reset period, regardless of maturity.
C. You might confuse an FRN with a zero-coupon bond structure, or hear 'duration = maturity' and assume it applies when there are no interim coupons. FRNs DO pay periodic coupons. They are floating coupons, not zero coupons. Zero-coupon bonds have duration equal to maturity; FRNs have duration equal to reset period.
Which of the following most likely explains why a corporation might choose to issue a floating rate note rather than a fixed-rate bond?
How sure are you?
Correct: A. The correct answer is To reduce interest expense if rates are expected to fall, and to match floating-rate assets on the balance sheet. Issuers choose FRNs when: (1) they expect rates to decline (floating coupons will fall, reducing interest expense vs. locking in today's rate), and (2) asset-liability matching: banks with variable-rate loan assets issue FRN liabilities to eliminate interest rate mismatch..
B. You might assume a corporation always prefers certainty in interest expense for budgeting. Fixed-rate bonds provide certainty; FRNs do the opposite. FRNs create MORE interest expense uncertainty for the issuer (coupons fluctuate with rates), not less. The correct motivation is the opposite: corporations issue FRNs when they WANT exposure to rate movements or need to match floating-rate assets.
C. You might confuse an FRN with a floor-embedded FRN. A floor embedded in an FRN does guarantee a minimum coupon, but this is a specific structural feature, not the general reason corporations issue FRNs. A standard FRN does not guarantee any minimum return to investors beyond the contractual formula.
For a TIPS bond, the coupon payment in period t is best most likely calculated as:
How sure are you?
Correct: A. The correct answer is Stated real coupon rate × inflation-adjusted principal in period t. TIPS coupon formula: Inflation-adjusted principal = Par × (CPI_t / CPI_issuance). Then: Coupon = real coupon rate × adjusted principal. The real coupon rate is fixed at issuance; the principal changes each period with CPI..
B. This is how every fixed-rate bond coupon is calculated, and candidates trained on fixed-rate bonds reflexively apply the same formula to TIPS. Applying the coupon rate to original par ignores the entire TIPS inflation-indexation mechanism. The coupon grows with inflation precisely because the principal is adjusted first.
C. TIPS have a 'nominal' coupon in the sense that it is a percentage rate, and candidates may confuse real coupon rate with nominal coupon rate terminology. TIPS have a REAL coupon rate (fixed, low, e.g., 1.5%), not a nominal one. The inflation compensation comes through principal adjustment. Using a nominal coupon rate on the adjusted principal would double-count the inflation adjustment.