Spring-03 Investments Zvi Wiener tel: Floaters and Inverse Floaters

Zvi WienerFloaters, Inverse Floaters slide 2 Straight bond Floater L0L0 100+L 6 L1L1 L2L2 L3L3 L4L4 L5L5

Zvi WienerFloaters, Inverse Floaters slide 3 How to treat Floaters Floater is similar to a constantly renewed loan with fixed spread (!). Thus the yield of a floater is equal to the yield on the basis plus the spread. Note that some of the Israeli government bonds have funny linkage to other bonds.

Zvi WienerFloaters, Inverse Floaters slide 4 Years Cashflow -100 L 0 L 1 L 2 L L 4 Pricing of AA Floaters Price 100+L L L L L 0

Zvi WienerFloaters, Inverse Floaters slide 5 Years Cashflow -100 L 0 +D L 1 +D L 2 +D L 3 +D 100+L 4 +D Pricing of Floaters Fair loan -100 L 1 +d L 2 +d L 3 +d 100+L 4 +d Difference ?? D-d

Zvi WienerFloaters, Inverse Floaters slide 6 Years Cashflow -100 L 0 +D L 1 +D L 2 +D L 3 +D 100+L 4 +D Pricing of Floaters Fair loan -100 L 1 +d L 2 +d L 3 +d 100+L 4 +d Difference ?? D-d Two types of duration: index duration and spread duration.

Zvi WienerFloaters, Inverse Floaters slide 7 Reverse (Inverse) Floater USD 5 year interest rates are 5%, however short term interest rates are Libor =2%. Libor = London Interbank offered rate on Bloomberg see FWCV + currency One can construct so-called reverse floater:

Zvi WienerFloaters, Inverse Floaters slide 8 Inverse Floater Years bond loan L 0 -L 1 -L 2 -L L 4 Reverse Fl L 1 10-L 2 10-L L 4 bond

Zvi WienerFloaters, Inverse Floaters slide 9 Duration of inverse floater Inverse Floater = 2*Bond – Floater IF = 2*B - F

Zvi WienerFloaters, Inverse Floaters slide 10 See Fabozzi: “The Handbook of Fixed Income Securities”, ch. 14, Floating Rate Securities. Duration of Floaters, see in T. Bjork, “Arbitrage Theory in Continuous Time”, Ch 15. Accrual Range, see Accrual Swaps in Hull, “Options, Futures, and Other Derivatives” Ch. 25