A three year floating rate note pays the three month benchmark plus 80 basis points and is issued at par. The issuer's credit spread widens to 200 basis points. Estimate the price, and give the note's interest rate duration and its spread duration.

A three year floating rate note pays the three month benchmark plus 80 basis points and is issued at par. The issuer's credit spread widens to 200 basis points. Estimate the price, and give the note's interest rate duration and its spread duration.

Approach: Value the note as par plus the present value of the fixed margin shortfall over the remaining life, then separate sensitivity to the reference rate from sensitivity to the credit spread.

96.5. The coupon resets to the benchmark every three months, so reference rate risk runs only to the next reset and the interest rate duration is about 0.25 years. The quoted margin of 80 basis points is fixed for the life of the note, so once the required spread is 200 the note pays 120 basis points a year too little for three years. Discounting that shortfall gives roughly 100 - 1.20 * 2.9, which is 96.5, where 2.9 is the spread duration, close to the maturity because spread risk is never reset away. The separation is what makes the instrument useful: a floating rate note holds credit risk with almost no rate risk, so swapping fixed rate bonds into floating rate notes changes the portfolio's rate exposure while leaving its credit exposure intact.

Follow-up: The note has a coupon floor at zero and the benchmark falls to -50 basis points. What is the embedded option and who is long it?

Key concepts: floating rate note, spread duration, interest rate duration, reset.