University:
Boston University
Course:
QST FE 200 | Principles of Finance
Academic year:

2023
Views:

338

Pages:

2
Author:

Rhianna Osborne

Appendix B: The Spread Data Spreads are not a common variable of analysis for financial economists, who prefer to focus on returns. As a practical matter, however, interest rate risk is frequently hedged, leaving credit risk as the focus. Credit spreads isolate the risk of default and the recovery rate. Thus, when assessing fixed income securities, investors focus on spreads as a common measure for determining how much they are being paid to bear the credit risk embedded in a security. For fixed rate instruments, the spread is the yield spread, i.e., the difference between the yield-to-maturity of the credit risky instrument and the benchmark instrument (LIBOR) with the same maturity. Floating rate instrument prices are converted to a spreads by determining the discount margin, which is the fixed amount to be added to the current LIBOR rate that is required to reprice the bond to par. The discount margin measures the yield relative to the current LIBOR rate and so does not take into account the term structure of interest rates. The discount margin, dm, satisfies the following relationship: where: P = Price of the floating rate note (FRN) per $100 face value; qm = Quoted margin on FRN; dm = discount margin; yi = Assumed value of the reference rate (LIBOR) in period i; n = number of period until maturity; m= number of period per year. The formula shows that if the quoted margin is equal to the discount margin, then the second term is zero and the FRN is valued at par. If the current price of the floater differs from par, then the discount margin is nonzero. The discount margin assumes that the cash flows over the remaining life of the bond are determined by the current reference rate value. The margin is selected so that the present value of the cash flows is equal to the security’s price. The discount margin is a measure which is similar to yield-to-maturity for fixed rate instruments. It expresses the price of an FRN relative to the current LIBOR level. See Fabozzi and Mann (2000).