Tell a floating-rate note's quoted margin apart from its discount margin
The idea
The quoted margin is the fixed spread added to the reference rate to set the coupon, and it is set at issuance. The discount margin, also called the required margin, is the spread over the reference rate the market currently demands, which reflects the issuer's credit risk and also the note's liquidity. When the two are equal the note prices at par. If the issuer's credit deteriorates, or the note becomes less liquid, the required margin rises above the quoted margin and the note trades below par; if credit improves it trades above. A floating-rate note therefore carries almost no interest rate risk but full exposure to its required spread, so its price is a direct reading of the spread the market wants, mostly for credit.
Formulas
Coupon on a floating-rate note
coupon rate = reference rate + quoted margin
- reference rate
- the market rate the note resets to, such as a policy or interbank rate
- quoted margin
- the fixed spread set at issue, in basis points
Reset each period, so the coupon follows the market and the price stays near par. The price drifts from par only when the issuer's credit moves: the quoted margin is fixed at issue and the discount margin the market now demands is not.
A practice question
What is the quoted margin on a floating-rate note?
- The fixed spread added to the reference rate to determine the coupon — correct
- The difference between the note's price and parWhy not: That gap is a *consequence* of the quoted margin differing from what the market requires, not the margin itself.
- The spread the market currently requiresWhy not: That is the discount margin, which moves daily. The quoted margin is fixed at issuance and never moves.
It is set at issuance and does not change. The market's required spread moves independently of it.
A harder one
A floating-rate note trades below par. What does this indicate?
- That the reference rate has risenWhy not: A rising reference rate raises the coupon at the next reset, which is exactly what keeps the price near par. It cannot explain a discount.
- That the required margin has risen — correct
- That the note is close to maturityWhy not: Approaching maturity pulls the price *toward* par, not away from it.
It now exceeds the quoted margin, which means the issuer's credit has deteriorated. Coupon resets remove the effect of the reference rate, so a discount to par must come from the spread, which is the market's credit assessment.
The hardest tier
Why does a floating-rate note carry credit risk but almost no interest rate risk?
- Because floating-rate notes are always short datedWhy not: Many run for years. The insulation comes from the reset frequency, not from the maturity.
- Because the reference rate is guaranteed by the issuerWhy not: The reference rate is observed from the market. No issuer guarantees it, and if one did that would be a fixed-rate bond.
- Because the coupon resets with the rate — correct
Only the fixed credit spread is left to be repriced. Duration is confined to the period until the next reset, while the spread does not reset and is exposed for the note's full life.
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