Can someone confirm/fix/further improve my logic here?
Why will an asset that receives floating rate payments likely have a lower duration than an asset that receives fixed rate payments?
My thought but I didn’t see this concept directly in the Derivatives section: If rates rise, the asset value declines. The rise in rates means you will collect a greater coupon payment, which puts more value earlier in the cash flows hence lowering duration and offsetting the asset price decrease (against a fixed payment)?
Recall that a bond that pays a coupon:
- below its YTM sells at a premium
- at its YTM sells at par
- above its YTM sells at a discount
The easiest floating-rate bond to visualize is a risk-free bond that pays LIBOR: at every coupon date its coupon resets to LIBOR, which is its YTM (because it’s risk-free). Therefore, its price is always near par, so its (effective) duration is near zero (i.e., not much price change when its yield (LIBOR) changes).
Makes perfect sense, thank you!
I’m allowed to make perfect sense only once a week. You got lucky.