Description of Overnight Floaters with Principal Adjustment and Its Advantages
6 Pages Posted: 18 Feb 2021
Date Written: December 24, 2020
Interest rate markets are moving away from term benchmarks to embrace overnight benchmarks more widely. This has created an issue for bonds and loan markets as direct application of the overnight standard mechanism, the composition, leads to coupons that are known only at the end of the accrual period. We provide a precise description of a less known convention for those products which has the same level of complexity that the direct method but has the important advantage to lead to coupons that are known at the start of the accrual period for all but the last coupon. This simple convention is apparently misunderstood, including in official regulatory documents, and it appears that a systematic description and formal analysis of its valuation and risk mechanism would be beneficiary for the market.
Keywords: bond, overnight, composition, simplicity, principal adjustment, loan
JEL Classification: G12, G13, G15, G23, K12
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