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CFA Level I · CFA Level I Exam

Yield and Yield Spread Measures for Floating-Rate Instruments

A floating-rate note pays a coupon equal to a reference rate plus a fixed quoted margin, so its coupon resets. Instead of yield to maturity, you measure the required margin. The discount margin is the spread over the reference rate that makes the discounted cash flows equal the price. Money market instruments use their own yield conventions.

What this chapter covers

This chapter covers how fixed income analysts measure return on instruments whose cash flows are not fixed. A floating-rate note (FRN) pays a coupon equal to a reference rate plus a quoted margin, and the coupon resets each period. Because the coupon moves with the market, the usual yield to maturity is a poor summary. You use spread measures instead.

The chapter moves in a clear line. First you learn how FRNs are built: the index rate, the quoted margin, the reset frequency, and features such as caps and floors. Then you learn the spread measures: quoted margin, required margin, and discount margin. Then you price an FRN by discounting each cash flow at the reference rate plus the required margin. Finally you cover money market instruments, which are quoted on a discount rate or add-on rate basis rather than the way bonds are quoted. To compare these instruments with bonds, you convert their yields to a bond equivalent yield.

This chapter builds on time value of money and bond pricing from earlier Fixed Income work. It also links to Quantitative Methods through the TVM keystrokes, to Derivatives through reference rates and swaps, and to Portfolio Construction when you compare short-term cash instruments. Questions are usually short calculations or concept checks, which suits the three-option format.

Fixed Income carries 11-14% of the 2027 Level I exam, and this chapter gives you compact, calculation-friendly questions. The ideas are few and the formulas are short, so well-prepared candidates can pick up marks quickly. The traps are in conventions: which rate is quoted, which day count applies, and whether the price sits above or below par. A candidate who learns these rules can answer in well under the suggested 90 seconds per question. There is no penalty for a wrong answer, so you should always answer, but accuracy here is within reach.

Yield and Yield Spread Measures for Floating-Rate Instruments: topics in the order to study them

  1. 1Floating-Rate Note Features and Index RatesYou need the structure first: reference rate, quoted margin, reset dates, caps, floors and the idea that coupons reset to the market.
  2. 2Spread Measures for Floating-Rate NotesOnce you know the structure, you can separate the quoted margin you are paid from the required margin the market demands.
  3. 3Pricing a Floating-Rate Note with Discount MarginPricing uses both earlier ideas: discount at the reference rate plus the required margin, and see why price moves above or below par at reset.
  4. 4Money Market Yield Measures and InstrumentsThis is a separate set of conventions built on the discount rate and add-on rate bases. It is easier after FRNs are clear, and it needs its own formulas and day counts, plus conversion to a bond equivalent yield for comparison.

How to prepare Yield and Yield Spread Measures for Floating-Rate Instruments

This chapter is short but full of conventions. Build the logic first, then drill the calculations until the steps are automatic.

  1. Write the FRN coupon in one line: coupon = reference rate + quoted margin, paid on the reset schedule. Say it aloud until it is automatic.
  2. Learn the margin vocabulary and compare quoted margin with required margin. Rule at a reset date: if the required margin is higher than the quoted margin, the FRN prices below par; if lower, above par; if equal, at par. Between reset dates, price also depends on the gap between the current reference rate and the rate already set for the current coupon.
  3. Practise pricing with a simple two or three period FRN. Discount each cash flow at (reference rate + required margin) for the period, and use the TVM keys on your TI BA II Plus or HP 12C to check.
  4. Create a one-page table for money market instruments with the quote basis (discount rate or add-on rate), day count, and formula for each. Practise converting between discount rate and add-on rate, and then to a bond equivalent yield for comparison with bonds.
  5. Do timed practice questions in sets of ten, allowing about 90 seconds each. For each wrong answer, name the exact convention or step you missed.
  6. Revise the sign logic last: higher required margin means lower price, and for given cash flows, a higher discount rate means a lower price.

Common mistakes in Yield and Yield Spread Measures for Floating-Rate Instruments

  • Treating the discount margin as yield to maturity.

    Fix: Remember that discount margin is a spread over the reference rate, not a total return. Add the reference rate back only if the question asks for a total rate.

  • Mixing up quoted margin and required margin.

    Fix: Quoted margin is in the contract and sets the coupon. Required margin is what the market demands and sets the discount rate. Label them in your working.

  • Getting the price direction wrong against par.

    Fix: At a reset date, if you are paid less margin than the market wants, the price must fall below par. Use that check to eliminate wrong options, and remember that between resets the gap between the current reference rate and the rate already set also matters.

  • Using annual rates for periodic cash flows.

    Fix: Convert the reference rate and margins to the coupon period first, then discount. Check that the frequency matches.

  • Applying the wrong day count or basis to money market yields.

    Fix: Underline the quote basis and day count in the stem before calculating, and keep a one-line formula for each instrument.

  • Forgetting that a discount rate is based on face value.

    Fix: Compute the price from the discount rate first, then derive the yield on the amount invested if the question asks for it.

Last-day revision: Yield and Yield Spread Measures for Floating-Rate Instruments

  • FRN coupon = reference rate + quoted margin, reset at each coupon date.
  • Quoted margin is fixed in the contract; required margin changes with credit risk and liquidity.
  • At a reset date, required margin above quoted margin: FRN prices below par.
  • At a reset date, required margin below quoted margin: FRN prices above par.
  • At a reset date, required margin equal to quoted margin: FRN prices at par.
  • Between reset dates, price also depends on the current reference rate versus the rate already set for the current coupon, so the par rule is not exact.
  • Discount margin is the spread over the reference rate that equates discounted cash flows to price.
  • Discount each FRN cash flow at reference rate plus required margin, adjusted for the period.
  • A cap limits the coupon from above and helps the issuer; a floor limits it from below and helps the investor.
  • Money market yields use different day counts and bases, so identify the convention before calculating.
  • A discount rate is quoted on face value, so for the same instrument it understates the yield on the amount invested (the add-on rate).
  • Money market instruments are quoted on a discount rate or add-on rate basis; the bond equivalent yield is a conversion for comparison with bonds, not a quote basis.
  • Always check whether a question wants a price, a margin, or a yield, and whether the period is annual or per coupon.

Yield and Yield Spread Measures for Floating-Rate Instruments practice questions

Yield and Yield Spread Measures for Floating-Rate Instruments in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Yield and Yield Spread Measures for Floating-Rate Instruments: frequently asked questions

What is a discount margin on a floating-rate note?

It is the spread over the reference rate that makes the present value of the FRN's cash flows equal its market price. It is the FRN equivalent of a required return. If it is higher than the quoted margin, the note trades below par at a reset date.

Why does a floating-rate note trade near par?

Its coupon resets to the current reference rate, so interest rate risk is small. Price differs from par mainly because the required margin differs from the quoted margin, which reflects credit risk or liquidity changes. At a reset date with equal margins, price is par. Between resets, price also reflects the current reference rate versus the rate set for the current coupon.

Do I need a calculator for this chapter?

Yes, for pricing and money market conversions. The TI BA II Plus or HP 12C is enough, using the TVM keys or simple arithmetic. Practise the keystrokes beforehand so you do not lose time in the exam.

How are money market yields different from bond yields?

Money market instruments are short-term and quoted on a discount rate or add-on rate basis, with day counts of 360 or 365 days. You may need to convert them to a bond equivalent yield to compare with bonds. Always check the quote basis first.