Which of the following statements regarding floating-rate securities is most accurate?
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Floating-rate securities have a coupon rate that resets periodically. The objective of this floating mechanism is to bring the coupon rate in line with the current market yield so that the bond sells at or near its par value, reducing interest rate risk compared to that of a fixed-rate security. In general, the longer the time until the next reset, the greater the interest rate risk of the floating-rate security. The interest rate risk of a floating-rate security decreases as the reset date approaches because the coupon reset will return the price to par, as long as the margin above the reference rate accurately reflects the bond’s risk. If this fixed margin does not reflect changes in the issuer’s creditworthiness, the bond’s price may differ from par at its reset date.
Which of the following statements about floating-rate bonds is NOT correct?
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Holding floating-rate bonds minimizes, but does not eliminate price fluctuations. The other statements are true.
The risk to a holder of a floating-rate bond that market rates will increase to the point where the bond behaves like a fixed-rate bond (increased price fluctuation) is known as:
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This is the correct definition of cap risk. Cap risk occurs with floating-rate bonds that have a cap placed on how high the coupon rate can go. Inflation risk refers to the risk that the rate of inflation will be higher than the investor anticipated, resulting in reduced purchasing power. An investor can reduce exposure to inflation risk by holding floating-rate bonds.
Which of the following is least likely to be given as a reason that the prices of floating-rate bonds fluctuate from par?
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Call risk pertains to callable bonds and is the risk of the bond issuer "calling the bond" when interest rates decrease. The issuer replaces the current bond with lower interest rate debt but the current bond holder usually loses due to having to replace their bond with a lower paying coupon bond. This has nothing to do with floating rate bonds. The rest of the choices are reasons why floating rate bonds fluctuate from par. With a cap, when the market yield is above its capped coupon rate, a floating-rate security will trade at a discount. With fixed rate margins, if the creditworthiness of the firm improves, the floater is less risky and will trade at a premium to par.
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