Floater answer - book 10 More on Duration Page 1 of 14...

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book 10 - More on Duration [2004-12-19] -- Page 1 of 14 Chapter 10 More on Duration Executive summary In this chapter we extend the concept of duration to fixed income securities and derivatives whose cash flow can change in response to changes in interest rates (floaters, interest rate swaps, and inverse floaters). In this case, computing duration requires considering both the changes in cash flow and the valuation of the modified cash flow with the new yield curve. As we shall see, this is often achieved using arbitrage-free pricing. This topic is of great practical relevance. First, interest rate swaps are by far the most important derivative security in terms of notional amounts outstanding (see chapters 1 & 13). Second, floating rate loans and securities (including inverse floaters) are an important segment of the fixed income market. We should also note that there are other fixed income securities whose cash flows can change with the level of interest rates, for example, callable and puttable bonds and mortgage backed obligations. However, given their option-like characteristics, we shall cover them in Part IV and Part VI. This chapter requires some understanding of simple, plain vanilla, interest rate swaps. (Readers of this book are surely familiar with this all-pervasive derivative security. However, a short primer can be found in chapter 13.) Contents 10.1 - Pricing and duration of floaters 10.2 - Duration of interest rate swaps (IRSs) 10.3 - Pricing and duration of inverse floaters (*) 10.4 - Duration of floaters paying a spread over the reference rate (*)
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book 10 - More on Duration [2004-12-19] -- Page 2 of 14 10.1 Pricing and duration of floaters 10.1.1 Floating rate bonds Floating rate bonds are usually denoted as floating rate notes ( FRNs ), or simply as floaters, and we shall use the three terms interchangeably. They are medium to long-term coupon bonds characterized by the fact that the rate for each coupon period is usually determined at the beginning of the coupon period itself, based on some relevant short- term money-market reference rate, most often LIBOR. The dates at which the interest rate is recalculated are known as resettlement dates or repricing dates. Coupons are usually paid semiannually or quarterly, in arrears. We should add that there is a flourishing market for floating rate loans that allows banks to mitigate the interest rate risk of extending medium- and long-term loans funded with short-term deposits. Floating rate loans and notes are one of the products developed in the early 1970s in response to the dramatic increase in interest-rate volatility that followed the collapse of the Bretton Woods system and the first oil crisis. In a volatile interest-rate scenario, the price of a FRN is relatively insensitive to fluctuations in market yields because the periodic coupon repricing synchronizes the FRN with current market conditions.
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This note was uploaded on 01/26/2010 for the course ADMS 4504 taught by Professor Lee during the Spring '08 term at York University.

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Floater answer - book 10 More on Duration Page 1 of 14...

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