Suppose that the coupon rate of a floating-rate security resets every six months at
a spread of 70 basis points over the reference rate.
If the bond is trading at below par value, explain whether the discount margin is greater than or less than 70 basis points.
If the bond is trading below par value, then the discount margin or assumed annual spread (basis points) will be greater than 70 basis points. This is because the spread must increase to make the present value of the cash flows less than the par value. This is illustrated in Exhibit 3-1 where the bond is trading below par and the spread (basis points) had to increase in order for the present value of the cash flows to fall to a level to equal the current trading value.
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