Question-71: So, what is used to determine the potential return on the floating rate security?

Answer: We can use the “discount margin” of a security.

Question-72: What is discount margin, in fixed income?

Answer: As you know to calculate the potential return on Floating Security, we cannot use the YTM (Yield to maturity). Hence, we have to use some other method that is known as Discount Margin. Discount Margin is against some reference like LIBOR. So, DM (discount margin) estimates the average spread or margin over the reference rate (e.g. LIBOR) that an investor can expect to earn over the life of security.

Question-73: What are the steps involved in calculating the Discount Margin?

Answer: There are following steps which are used to calculate the discount margin.

• Constant Reference Rate Assumption: Determine or calculate the cashflow assuming that the reference rate does not change over the life of security.
• Margin: Now select the margin also known as spread, which is expected.
• Discounting: Now discount the cash-flows received in step-1 above by the current value of reference rate + spread(step-2).
• Result: Now compare the present value with the calculated cash-flow in step-3. If present value is same as current price. Then this is the discount margin or spread assumed in step-2. If not equal then go back to step-2 and try different margin.

Hence, investor should know what spread he is expecting on the Reference Rate. And calculate the bond price accordingly. If it is same as his calculated price, it means bond is being sold at par.

Question-74: What are the issues with the DM (Discount Margin) to calculate the potential return?

Answer: There are mainly two issues with the DM method for calculating potential return for the Floating Rate Security, these are below

• In DM (Discount Margin), it is assumed that reference rate would remain constant till the security matures.
• Usually, floating rate security has a cap and it does not consider that.

Question-75: What is the convention method to calculate the return on Fixed Income?

Answer: Yield to maturity and Yield to call are the conventional method to calculate the return on Fixed Income bond.