LM08 Yield and Yield Spread Measures for Floating-Rate Instruments 2025 Level I Notes

LM08 Yield and Yield Spread Measures for Floating-Rate

Instruments

1. Introduction ...........................................................................................................................................................2
2. Yield and Yield Spread Measures for Floating-Rate Notes ..................................................................2
3. Yield Measures for Money Market Instruments ......................................................................................4
Summary......................................................................................................................................................................9

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LM08 Yield and Yield Spread Measures for Floating-Rate Instruments 2025 Level I Notes

1. Introduction
This learning module covers:
 Yield spread measures for floating rate instruments – instruments with variable rather
than fixed coupons
 Yield measures for money market instruments – instruments with original maturities
of one year or less
2. Yield and Yield Spread Measures for Floating-Rate Notes
Floating-rate notes (FRN) are instruments where coupon/interest payments change from
period to period based on a reference interest rate. Some important points to note about
floating-rate notes:
 The objective is to protect the investor from volatile interest rates.
 The reference rate, usually a money market instrument such as a T-bill or a market
reference rate (MRR), is used to calculate the interest payments. This rate is
determined at the beginning of each period, but the interest is actually paid at the end
of the period. This payment structure is called ‘in arrears.’
 Often, the coupon rate of an FRN is not just the reference rate, but a certain number of
basis points, called the spread, is added to the reference rate.
 The specified yield spread over the reference rate is called the quoted margin.
 The spread remains constant throughout the life of the bond. The amount of spread
depends on the credit quality of the issuer.
Example of a Floating Rate Note
Moody’s assigned a long-term credit rating of A2 to Nationwide, U.K.’s largest building
society. Nationwide issued a perpetual floating-rate bond with a coupon rate of 6-month
MRR+ 240 basis points. The 2.4% quoted margin is a reflection of its credit quality. On the
other hand, AAA-rated Apple sold a three-year bond at 0.05% over 3-month MRR in 2013 as
its credit risk was very low.
Coupon rate of a FRN = reference rate + quoted margin
The required margin is the spread demanded by the market. We saw that the quoted
margin, or the spread over the reference rate, is fixed at the time of issuance. But what
happens if the floater’s credit risk changes and investors demand an additional spread for
bearing this risk? The required margin is the additional spread over the reference rate such
that the FRN is priced at par on a rate reset date. If the required margin increases
(decreases) because of a credit downgrade (upgrade), the FRN price will decrease (increase).
For example, assume a floater has a coupon rate of 3-month MRR plus 50 basis points. Six
months after issuance, the issuer’s credit rating is downgraded and the market demands a
required spread of 75 basis points. The coupon paid by the floater is lower than what the

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LM08 Yield and Yield Spread Measures for Floating-Rate Instruments 2025 Level I Notes

market demands. As a result, the floater would be priced at a discount to par as the cash flow
is now discounted at a higher rate. The amount of the discount will be the present value of
differential cash flows, i.e., the difference between the required and quoted margins.
Conversely, if the credit rating of the issuer improves, the required margin would be below
the quoted margin, and the market will demand a lower spread.
How required margin affects a floater’s price at reset date
Relationship between quoted and Floater’s price at reset date
required margin
Required margin = quoted margin Par
Required margin > quoted margin Discount (below par)
Required margin < quoted margin Premium (above par)
The required margin is also called the discount margin. FRNs can be valued using the
model shown below.
FV FV FV
(MRR + QM) ∗ (MRR + QM) ∗ (MRR + QM) ∗ + FV
m m m
PV = + + ⋯+
MRR+DM 1 MRR+DM 2 MRR+DM N
(1 + m
) (1 + m
) (1 + )
m

where:
PV = present value of the FRN
MRR = the market reference rate, stated as an annual percentage rate
QM = quoted margin, stated as an annual percentage rate
FV = future value paid at maturity, or the par value of the bond
m = periodicity of the floating-rate note, or the number of payment periods per year
DM = discount margin; the required margin stated as an annual percentage rate
N = number of evenly spaced periods to maturity
Equation 1 for reference:
PMT PMT PMT+FV
PV of bond = (1+r)1 + (1+r)2 + ⋯ + (1+r)N

How to interpret the floating-rate note equation:

 Think of it as an extension of Equation 1, we will draw similarities between the two
equations.
FV
 (MRR + QM) ∗ is the first interest payment similar to PMT of Equation 1, which is
m
the coupon payment per period.
 (MRR + QM) is the annual rate.
 Since it is divided by periodicity we get the interest payment for that period.
 In Equation 1, cash flows are discounted at 1 + r. For FRN, the cash flow for the first
MRR+DM MRR+DM 2
period is discounted at 1+ , for the second period at (1 + ) , and so on.
m m

This is considered a simple model because of the following assumptions:

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LM08 Yield and Yield Spread Measures for Floating-Rate Instruments 2025 Level I Notes

 The value is calculated only on reset dates. There is no accrued interest, so the flat
price is the full price.
 The model uses a 30/360 day-count convention, which means periodicity is always an
integer.
 The same reference rate is used in the numerator and denominator for all payment
periods.
Example
A 3-year Italian floating-rate note pays 3-month MRR plus 0.75%. Assuming that the floater
is priced at 99, calculate the discount margin for the floater if the 3-month MRR is constant
at 1% (assume 30/360 day-count convention).
Solution:
The interest payment for each period is (1.00% + 0.75%) / 4 = 0.4375%.
The keystrokes to calculate the market discount rate are: PV = -99, PMT = 0.4375, FV = 100,
N = 12, CPT I/Y = 0.5237 * 4, I/Y = 2.09%
The discount margin for the floater is 2.09% - 1% = 1.09% or 109 bps.
3. Yield Measures for Money Market Instruments
Money market instruments are short-term debt securities. They have maturities of one year
or less, ranging from overnight repos to one-year certificates of deposit.
Differences in Bond Market and Money Market Yields
Bond Market Yields Money Market Yields
YTM is annualized and compounded. Rate of return is annualized but not
compounded; stated on a simple interest
basis.
YTM calculated using the standard time Non-standard calculation using discount
value of money approach using a financial rates and add-on rates.
calculator.
YTM stated for a common periodicity for Instruments with different times to
all times to maturity. maturity have different periodicities for
the annual rate.
The calculation of interest of a money market instrument is different from calculating
accrued interest on a bond. Money market instruments can be classified into two categories
based on how the rates are quoted:
 Discount rates: T-bills, commercial paper (CP), and banker’s acceptances are discount
instruments. It means they are issued at a discounted price, and pay par value at
maturity. They do not make any payments before maturity. The difference between the
purchase price and par value at redemption is the interest earned. Note: Do not confuse

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LM08 Yield and Yield Spread Measures for Floating-Rate Instruments 2025 Level I Notes

this discount rate with the rate used in TVM calculations.

Price of a money market instrument quoted on a discount basis
days to maturity
PV = FV x (1- x DR)
year

where:
PV = present value of the money market instrument
FV = face value of the money market instrument
days to maturity = actual number of days between settlement and maturity
year = number of days in the year. Most markets use a 360-day year.
DR = discount rate, stated as an annual percentage rate (APR)
Money market discount rate
Year FV−PV
Money market discount rate DR = (days to maturity) ∗ FV

FV-PV = interest earned on the instrument (this is the discount)

year
days
= periodicity of the instrument

 Add-on rates: Bank term deposits, repos, certificates of deposit, and indices such as
Libor/Euribor are quoted on an add-on basis. For a money market instrument quoted
using an add-on rate, interest is added to the principal to calculate the redemption
amount at maturity. In simple terms, if PV is the initial principal amount, days is the days
to maturity, and year is the number of days in a year, then the amount to be paid at
days to maturity
maturity is: FV = PV + PV x AOR x year
where AOR is the add-on rate stated on
an annualized basis.
Present value or price of a money market instrument quoted on an add-on basis
FV
PV = Days to maturity
1+ x AOR
Year

where:
PV = present value of the money market instrument
FV = amount paid at maturity including interest
days = number of days between settlement and maturity
year = number of days in a year
AOR = add-on rate stated as an annual percentage rate
Add-on rate
Year FV−PV
AOR = (Days) ∗
PV

Instructor’s Note
The primary difference between a discount rate (DR) and an add-on rate (AOR) is that the

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LM08 Yield and Yield Spread Measures for Floating-Rate Instruments 2025 Level I Notes

interest is included on the face value of the instrument for DR whereas it is added to the
principal in case of AOR.

Example
Suppose that a banker’s acceptance will be paid in 91 days. It has a face value of $1,000,000.
It is quoted at a discount rate of 5%. What is the price of the banker’s acceptance?
Solution:
Days to maturity
PV = FV * (1 − Year
∗ DR)

FV = 1,000,000
Days = 91
Year = 360 days
DR = 5%
91
PV = 1,000,000 ∗ (1 − 360 ∗ 0.05) = $987,361

Suppose that a Canadian pension fund buys a 180-day banker’s acceptance (BA) with a
quoted add-on rate of 4.38% for a 365-day year. If the initial principal amount is CAD 10
million, what is the redemption amount due at maturity?
Solution:
Year FV − PV
AOR = ( ) ∗
Days PV
365 FV−10,000,000
0.0438 = 180 ∗ 10,000,000

FV = $10,216,000
Comparing Discount Basis with Add-On Yield
There are two approaches to compare the return of two money market instruments if one is
quoted on a discount basis and the other on an add-on basis.
First approach: If you don’t want to memorize one more formula, follow this approach:
1. Determine the present value of the instrument quoted on a discount basis.
2. Use the present value to determine the AOR.
3. Compare the two AORs to see which instrument offers a better return.
Second approach: Use the following relationship between AOR and DR:

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LM08 Yield and Yield Spread Measures for Floating-Rate Instruments 2025 Level I Notes

Relationship between AOR and DR

DR
AOR = Days to maturity
1 − Year
∗ DR

Example
A T-bill with a maturity of 90 days is quoted at a discount rate of 5.25%. Its par value is $100.
Calculate the add-on rate.
Solution:
Using the first approach:
FV = 100; Days = 90; Year = 360 days; DR = 5.25%
90
PV = 100 ∗ (1 − 360 ∗ 0.0525) = $98.687
360 100−98.687
AOR = 90
* 98.687
= 5.32%.

Using the second approach:

0.0525
AOR = 90 = 5.3198%
1− ∗ 0.0525
360

Example
Money market Instrument Quotation Basis Number of Days in the Year Quoted Rate
A Discount Rate 360 3.23%
B Discount Rate 365 3.46%
C Add-on Rate 360 3.25%
D Add-on Rate 365 3.35%
Given the four 90-day money market instruments, calculate the bond equivalent yield for
each of them. Which instrument offers the highest rate of return if the credit risk is the
same?
Solution:
90
A. The price of instrument A is 100 – (360 × 3.23) = 99.1925 per 100 of par value. The bond
365 100 – 99.1925
equivalent yield is ( 90 ) × = 3.30%.
99.1925
90
B. The price of instrument B is 100 – (365 × 3.46) = 99.1468 per 100 of par value. The bond
365 100 – 99.1468
equivalent yield is ( 90 ) × = 3.49%.
99.1468
90
C. The redemption amount per 100 of principal is 100 + (360 × 3.25) = 100.8125. The bond
365
equivalent yield is × (100.8125 - 100) = 3.295%.
90
D. The quoted rate for instrument D of 3.35% is the bond equivalent yield. Instrument B

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LM08 Yield and Yield Spread Measures for Floating-Rate Instruments 2025 Level I Notes

offers the highest rate of return on a bond equivalent yield basis.

Periodicity of the Annual Rate
Another difference between yield measures in the money market and the bond market is the
periodicity of the annual rate. Because bond yields to maturity are computed using interest
rate compounding, there is a well-defined periodicity. For instance, bond yields to maturity
for semi-annual compounding are annualized for a periodicity of two. Money market rates
are computed using simple interest without compounding. In the money market, the
periodicity is the number of days in the year divided by the number of days to maturity.
Therefore, money market rates for different times to maturity have different periodicities.
Number of days in the year
Periodicity of a money market instrument =
Number of days to maturity

Example
A 90-day T-bill has a BEY of 11%. Calculate its semiannual bond yield.
Solution:
The 11% BEY of the T-bill is based on a periodicity of 365/90. The periodicity of a
semiannual bond is 2. Give this information, we can create the equation shown below and
solve for r. We will get r = 0.1115 = 11.15%.
365
( )
90
0.11 r 2
(1 + 365 ) = (1 + )
2
90

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LM08 Yield and Yield Spread Measures for Floating-Rate Instruments 2025 Level I Notes

Summary
LO: Calculate and interpret yield spread measures for floating-rate instruments.
Floating-rate notes (FRN) are instruments where coupon/interest payments change from
period to period based on a reference interest rate. The coupon rate of a FRN is equal to the
sum of reference rate and quoted margin.
FV FV FV
(MRR + QM) ∗ (MRR + QM) ∗ (MRR + QM) ∗ + FV
m m m
PV = + + ⋯+
MRR+DM 1 MRR+DM 2 MRR+DM N
(1 + ) (1 + ) (1 + )
m m m

The quoted margin is a specified spread over or under the reference rate. The required
margin, also known as the discount margin, is the spread required by investors.
LO: Calculate and interpret yield measures for money market instruments.
Money market instruments are short-term debt securities. They have maturities of one year
or less, ranging from overnight repos to one-year certificates of deposit. Money market
instruments can be classified into two categories based on how the rates are quoted;
discount rate and add on rate.
days to maturity
PV = FV ∗ (1 − ∗ DR)
year
FV
PV = days to maturity
1 + year
∗ AOR

DR
AOR = days to maturity
1 − year
∗ DR

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