A floater is a debt obligation whose coupon rate is reset at designated dates based on the value of some designated reference rate. The coupon formula for a pure floater (i.e., a floater with no embedded options) can be expressed as follows:
coupon rate = reference rate ± quoted margin
The quoted margin is the adjustment (in basis points) that the issuer agrees to make to the reference rate. For example, consider a floating rate note issued by Enron Corp. that matured on March 30, 2000. This floater made quarterly cash flows and had a coupon formula equal to 3-month London Interbank Offered Rate (LIBOR) plus 45 basis points. Under the rubric of floating-rate securities, there are several different types of securities with the feature that the coupon rate varies over the instrument’s life. A floater’s coupon rate can be reset semi-annually, quarterly, monthly or weekly. The term “adjustable-rate” or “variable-rate” typically refers to those securities with coupon rates reset not more than annually or based on a longer-term interest rate. We will refer to both floating-rate securities and adjustable-rate securities as floaters.
As noted, the reference rate is the interest rate or index that appears in a floater’s coupon formula and it is used to determine the coupon payment on each reset date within the boundaries designated by embedded caps and/or floors. Common reference rates are LIBOR (with different maturities), Treasury bills yields, the prime rate, the federal funds rate, and domestic CD rates. There are other reference rates utilized in more specialized taxable fixed-income markets such as the mortgage backed securities and asset-backed securities markets. For example, the most common reference rates for adjustable-rate mortgages (ARMs) or collateralized mortgage obligation (CMO) floaters include: (1) the 1-year Constant Maturity Treasury rate (i.e., 1-year CMT); (2) the Eleventh District Cost of Funds (COFI); (3) 6-month LIBOR; and (4) the National Monthly Median Cost of Funds Index.