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Question

Which of the following risk(s) is/are Floating-rate bonds designed to minimise?

A Default risk Correct Answer Incorrect Answer
B Systemic risk Correct Answer Incorrect Answer
C Interest rate risk Correct Answer Incorrect Answer
D Liquidity risk Correct Answer Incorrect Answer
E Redemption risk Correct Answer Incorrect Answer

Solution

Floating Rate Bonds  (FRBs) are  bonds  that  have  a  variable  coupon,  equal  to  a  money  market reference  rate (like MIBOR or LIBOR) plus  a  quoted  spread  (i.e., quoted margin). ·         Floating rate bonds allow the investor to earn a rate of interest income tied to current interest rates. As such, FRBs carry little interest rate risk. ·         Its price shows very low sensitivity to changes in market interest rates. When market rates rise,  the  expected  coupons  of  the  FRB  increase  in  line  with  the  increase  in forward  rates,  which  means  its price  remains  constant. Thus,  FRBs  differ from fixed  rate  bonds,  whose  prices  decline  when  market  rates  rise.  ·         As  FRBs  are very less sensitive  to  interest  rate  risk,  they  are  considered  conservative investments for investors who believe market rates will increase.

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