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I am trying to calculate the yield and trading margin on an AUD FRN in a robust manner. I am hoping someone can help with a few details.

I am forecasting cash flows and solving for the discount rate that discount's these cash flows to the current price which will give me the yield.

  1. How can I estimate the future value of 3mBBSW?

BBSW Rates: https://www2.asx.com.au/connectivity-and-data/information-services/benchmarks/benchmark-data/bbsw

BBSW Futures: https://www2.asx.com.au/markets/trade-our-derivatives-market/derivatives-market-prices/short-term-derivatives

For arguments sake lets say this FRN's coupon is calculated as 3MBBSW + coupon margin. In order to accurately forecast the coupon component of the future cash flows I must estimate the future rates of 3mBBSW. What is the best way to do this? 3mBBSW has a futures market - is there a way to extract from this the market's current expectation of future 3mbbsw?

  1. How do you then calculate trading margin?

As I understand it to calculate the trading margin of the security we would take the above calculated yield and subtract the rate of the swap curve at the corresponding tenor.

How can I construct the underlying swap curve? Is it based on the values of BBSW? If so how do I use these values to construct the swap full curve?

Hopefully this is all clear. I have looked everywhere and can't find any answers specifically relating to the AUD market.

Many thanks for your help.

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1 Answer 1

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I struggled to find a straight answer here across many different sources so I hope this helps folks in the future.

The yield to maturity/call on a floating rate note is calculated by discounting the sum of all of its cash flows to maturity/call.

Given that the coupons are going to change we must estimate what they will be in the future. The coupons are made up of two components, the fixed coupon margin and the underlying rate to which the margin is added to calculate what the issuer will pay in coupon.

The underlying rate used is different around the world but essentially it is the risk-free rate for a particular period (three months, six months, etc). BBSW is currently used in Australia. For example, the 3mBBSW is the risk-free rate for 3 months. We must therefore estimate the risk free rate at different intervals through the life of the bond/security.

We use the market's expectation of interest rates to best estimate the future risk free rate. The market's expectation of future interest rates can be taken from forward rates. The best estimate in Australia for the risk-free rate is the Australian Government bond rate. We therefore need to get the forward rate (e.g. forward three month rate) at each coupon payment date for the security. In order to do this we take the current Australian Government Yield Curve, convert this to a zero-coupon curve (see answer here), and then pull the forward curves out of this zero-coupon curve. Then we have estimates of the future BBSw to be added to the coupon margin to calculate the coupon payment.

SECONDLY, to calculate the trading margin we must subtract the yield of the particular security from the risk-free rate of the same tenor. The risk free rate will be the zero-coupon Australian Government bond curve constructed in the previous step.

I hope this is helpful to someone in the future. Please ask any questions or make suggestions.

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