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Estimating AUD Floating-Rate Note Yield and Trading Margin

Article Quant Q&A · Author: JPI
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Summary

The document explains an approach to valuing Australian dollar floating-rate notes whose coupons combine a fixed margin with three-month BBSW. To estimate future coupon cash flows, it proposes using forward rates inferred from the Australian government bond curve: convert the observed yield curve to a zero-coupon curve, then derive forward rates for the coupon dates. Add the note’s coupon margin to those forecasts to project payments, and discount the projected cash flows to maturity or call to obtain yield.

For trading margin, the answer compares the security’s yield with the risk-free rate for a matching tenor, using a zero-coupon Australian government curve. This offers a practical outline rather than a complete market convention or calibration procedure. It does not explain curve bootstrapping, day-count and compounding choices, credit or liquidity adjustments, or how BBSW futures prices might be interpreted; its use of government forwards as BBSW expectations is a simplifying assumption.

Key ideas

  • Project floating coupons by adding the contractual margin to forward estimates of the underlying reference rate.
  • The proposed rate estimates come from converting the Australian government yield curve to zero rates and deriving forwards.
  • Discount projected coupons and principal to maturity or call to calculate the note’s yield.
  • Compare the note yield with a matching-tenor government zero rate to estimate trading margin.
  • The outline leaves market conventions and the relationship between government forwards and BBSW unspecified.

Tags

Fixed incomeDerivatives pricingCarry
Full text
# How do I calculate yield and trading margin of an Australian Dollar floating rate note?


# How do I calculate yield and trading margin of an Australian Dollar floating rate note?












I am trying to calculate the yield and trading margin on an AUD FRN in a robust manner. I am hoping someone can help with a few details.

I am forecasting cash flows and solving for the discount rate that discount's these cash flows to the current price which will give me the yield.

- How can I estimate the future value of 3mBBSW?

BBSW Rates: https://www2.asx.com.au/connectivity-and-data/information-services/benchmarks/benchmark-data/bbsw

BBSW Futures: https://www2.asx.com.au/markets/trade-our-derivatives-market/derivatives-market-prices/short-term-derivatives

For arguments sake lets say this FRN's coupon is calculated as 3MBBSW + coupon margin. In order to accurately forecast the coupon component of the future cash flows I must estimate the future rates of 3mBBSW. What is the best way to do this? 3mBBSW has a futures market - is there a way to extract from this the market's current expectation of future 3mbbsw?

- How do you then calculate trading margin?

As I understand it to calculate the trading margin of the security we would take the above calculated yield and subtract the rate of the swap curve at the corresponding tenor.

How can I construct the underlying swap curve? Is it based on the values of BBSW? If so how do I use these values to construct the swap full curve?

Hopefully this is all clear. I have looked everywhere and can't find any answers specifically relating to the AUD market.

Many thanks for your help.

## Answer by JPI (score 0)

https://quant.stackexchange.com/a/69866

I struggled to find a straight answer here across many different sources so I hope this helps folks in the future.

The yield to maturity/call on a floating rate note is calculated by discounting the sum of all of its cash flows to maturity/call.

Given that the coupons are going to change we must estimate what they will be in the future. The coupons are made up of two components, the fixed coupon margin and the underlying rate to which the margin is added to calculate what the issuer will pay in coupon.

The underlying rate used is different around the world but essentially it is the risk-free rate for a particular period (three months, six months, etc). BBSW is currently used in Australia. For example, the 3mBBSW is the risk-free rate for 3 months. We must therefore estimate the risk free rate at different intervals through the life of the bond/security.

We use the market's expectation of interest rates to best estimate the future risk free rate. The market's expectation of future interest rates can be taken from forward rates. The best estimate in Australia for the risk-free rate is the Australian Government bond rate. We therefore need to get the forward rate (e.g. forward three month rate) at each coupon payment date for the security. In order to do this we take the current Australian Government Yield Curve, convert this to a zero-coupon curve (see answer here), and then pull the forward curves out of this zero-coupon curve. Then we have estimates of the future BBSw to be added to the coupon margin to calculate the coupon payment.

SECONDLY, to calculate the trading margin we must subtract the yield of the particular security from the risk-free rate of the same tenor. The risk free rate will be the zero-coupon Australian Government bond curve constructed in the previous step.

I hope this is helpful to someone in the future. Please ask any questions or make suggestions.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.