A 3-year FRN pays SOFR + 80 bps. Six months in, credit deteriorates and the market demands SOFR + 120 bps. The coupon is unchanged. Where does price go, and how do you size the discount?
A floating-rate note resets its coupon each period using a market reference rate (MRR) such as SOFR, plus a credit spread set at issuance called the quoted margin (QM). The QM compensates investors for the issuer's credit risk relative to the reference benchmark. Once issued, QM is locked.
The market's view of fair credit compensation can drift. The spread investors require today is the required margin, also called the discount margin (DM). DM is the floating-rate analogue of yield to maturity: it is the spread that makes discounted cash flows equal current price, the yield spread you calculate for the note and then interpret against QM.
KEY: Coupons reset with the reference rate, so reference-rate moves do not drive FRN price. Only the gap between QM (fixed) and DM (variable) drives price.
Common mistakes
- Treating reference-rate moves as price drivers. FRN coupons reset, so the reference rate flows through to cash flow, not price. Only QM-vs-DM moves price. Trap: marking down an FRN because SOFR rose.
- Discounting at the reference rate alone. The discount rate is MRR + DM, not MRR. Trap: omitting the discount margin and getting par on a credit-impaired note.
- Comparing discount yields directly to add-on yields. A 4.50% discount yield is not equivalent to a 4.50% add-on yield. Trap: ranking a T-bill above a CD because the quoted rate looks higher (or lower) without converting to BEY.
Bottom line
- FRN coupon = reference rate + quoted margin (QM), reset each period; the quoted margin is fixed at issuance.
- Required margin (discount margin, DM) is the spread the market demands now; price moves only with DM versus QM, never with the reference rate.
- DM = QM → par; DM > QM → discount; DM < QM → premium.
- Discount-basis yield (T-bills, CP, BAs) is quoted on face value over a 360-day year.
Exam shortcut
For FRN pricing direction, remember "DM beats QM, price retreats" (DM > QM = discount). For yield conventions: T-bills, CP, BAs = discount/360/face; CDs, repos = add-on/365 or 360/price. Before comparing any two money-market instruments, restate both as BEY (365-day, divide by price). A discount yield is always the smallest of the three measures for the same instrument; the add-on 365 (BEY) is always the largest.
The full lesson (about 1,639 words, 11 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- yield measures floating-rate instruments
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