TABLE OF CONTENTS Floating-rate notes, FRNs or floaters for short, are among the simplest debt instruments. They are essentially bonds with a time-varying coupon. In this chapter we go over the basics of FRNs and introduce some notation and concepts that will be used throughout the remainder of the book.
Floating-rate notes are not credit derivatives, but they are featured prominently in the discussion of so many of them such as credit default swaps, asset swaps, and spread options that we decided to give them their own chapter in this book.
The main reason for the close link between FRNs and credit derivatives is that, as we shall see below, the pricing of a floater is almost entirely determined by market participants perceptions of the credit risk associated with its issuer. As such, floaters are potentially closer to credit default swaps than to fixed-rate corporate notes, which, as the name suggests, are bonds with a fixed coupon.
The variable coupon on a floating-rate note is typically expressed as a fixed spread over a benchmark short-term interest rate, most commonly three- or six-month LIBOR (London Interbank Offered Rate). LIBOR is the rate at which highly rated commercial banks can borrow in the interbank market. Therefore, one can think of LIBOR as reflecting roughly the credit quality of borrowers with credit ratings varying between A and AA, and thus such borrowers are able to issue FRNs with a spread that is either zero or close...
