Duration-matching is an approximation that usually suffices. But most investors don’t see a 10-year floater with monthly resets as the same as a 1-year floater with monthly resets, or as a 1-month fixed loan. To tell them apart, you need the forward rate information embedded in the yield curve.
What the yield curve implies
The Treasury curve shows the fixed rates investors demand to lend to the US government; it defines the risk-free rate. For floaters, the swap curve matters too: the fixed rate one highly rated institution pays another in exchange for floating payments. (The guide’s examples use LIBOR swaps; today’s US market uses SOFR.) Implied in any curve are:
- Spot rates: the rate for each maturity if no interest were paid until maturity.
- Forward rates: the market’s expected path of future rates.
A simple worked example
Assume a 1-year Treasury at 1% and a 2-year at 2%, both at par with annual coupons. The 1-year spot rate is 1%. Solving for the 2-year spot rate gives about 2.01%. The 1-year rate one year forward is then about 3%. Intuitively, to earn roughly 2% a year over two years while earning 1% in year one, you need about 3% in year two. That is the market’s expectation, not a guarantee.
Applying it to floaters
Build a forward curve for the floater’s index from the swap curve. Project the floater’s cash flows using the forward rate at each reset, plus prepayment and default assumptions. Then compute its yield and compare directly with fixed-rate or other floating assets.
In the guide’s example, a 5-year floater and a 5-year fixed loan both priced at +100 bps look different at first: the floater’s initial coupon is lower. But once forward rates are included, their yields are nearly identical. Judging the floater on its starting coupon ignores the curve’s expectation that short rates will rise.
Shortcut: for par-priced assets, add the spread to the swap rate at the floater’s WAL. Here, 2% + 100 bps = 3%. The closer the asset is to a bullet maturity, the better the approximation.
What about Prime-based HELOCs?
Prime has no explicit forward curve, but it moves in lockstep with Fed Funds. Use the Fed’s dot plot, analyst consensus or Fed Funds futures (Bloomberg’s WIRP), rounding to Prime’s 25 bp steps.