The Valuation of Floating Rate Instruments - Theory and Evidence

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Abstract
A framework for valuing floating rate notes is developed and used to examine the effects of (1) lags in the coupon averaging formula, (2) special contractual features and (3) default risk. Evidence on a sample of U.S. floaters is presented and indicates that these notes sold at significant discounts over the sample period. We find that while the lag structure in the coupon formulas and the special contractual features make these notes more variable, they are unable to account for the magnitude of the observed discounts. Based on numerical analysis of a valuation model with default, we conclude that the fixed default premium embodied in the coupon formula at the time of issuance of a typical note is inadequate to compensate for the time-varying default premiums demanded by investors, who will treat other corporate short-term paper as close substitutes: the observed discounts are most consistent with this hypothesis.
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