Variable-Rate Security

What is a Variable-Rate Security?

Variable-rate securities, also known as floating-rate securities, are debt instruments where the interest payments fluctuate based on changes in a benchmark interest rate. Unlike fixed-rate securities, which pay a constant interest rate until maturity, the yield on variable-rate securities adjusts periodically. This adjustment usually aligns with rates such as the LIBOR (London Interbank Offered Rate) or the federal funds rate in the United States.

Key Characteristics of Variable-Rate Securities:

Interest Rate Adjustment: The rate is typically adjusted at regular intervals, such as monthly or quarterly.
Market Rate Index: The interest rate is pegged to a recognized interest rate index.
Interest Rate Risk Mitigation: Investors’ exposure to interest rate risk is reduced since the security adjusts with market conditions.
Coupon Payments: Payments can increase in a rising interest rate environment and decrease when rates fall.

Examples of Variable-Rate Securities

Floating-Rate Notes (FRNs)

Floating-rate notes are types of variable-rate bonds that pay interest quarterly or semiannually. The interest rate on FRNs is typically linked to a benchmark, such as LIBOR, and can offer higher or lower yields depending on market conditions.

Eurobonds

Eurobonds that offer floating interest rates emphasize funding flexibility. They are typically issued in a currency different from that of the country in which the bond is issued. Their interest payments fluctuate with prevailing interest rates.

90-Day Certificates of Deposit (CDs)

These short-term debt instruments offer variable interest rates that adjust periodically. They are a popular choice for investors looking for short-term investment opportunities with the advantage of adjusting returns in line with market interest rates.

Frequently Asked Questions (FAQs)

What is the primary advantage of investing in variable-rate securities?

The primary advantage is the ability to keep pace with interest rate changes, which can be beneficial in a rising interest rate environment.

How frequently do interest rates on variable-rate securities adjust?

Adjustment intervals can vary but are commonly monthly, quarterly, or semi-annually.

Are variable-rate securities considered safe investments?

While they offer protection against interest rate risk, the main risk is the uncertainty of income streams due to fluctuating interest payments.

How are variable-rate securities different from fixed-rate securities?

Fixed-rate securities offer stable and predictable interest payments, whereas variable-rate securities adjust with market conditions, leading to potential variability in income.

Can I reinvest the interest payments from variable-rate securities?

Yes, the interest payments received can be reinvested, and this can impact the yield depending on the reinvestment rates.

Floating-Rate Notes (FRNs): Debt instruments paying variable interest based on a benchmark rate.
Eurobonds: Bonds issued in a currency not native to the country of issuance, often with floating interest rates.
Certificates of Deposit (CDs): Short- to medium-term time deposits offered by banks, typically with fixed or variable interest rates.
LIBOR: A benchmark rate that banks charge each other for short-term loans, commonly used to set rates for floating-rate securities.
Interest Rate Risk: The potential for investment losses due to changes in interest rates.

Online References

Suggested Books for Further Studies

“Fixed Income Analysis” by Frank J. Fabozzi: A comprehensive guide covering different types of fixed-income investments, including variable-rate securities.
“Bond Markets, Analysis, and Strategies” by Frank J. Fabozzi: Offers insights into bond markets along with a focus on rate-sensitive securities.
“The Handbook of Fixed Income Securities” by Frank J. Fabozzi: An authoritative book on the fixed-income market, providing detailed discussions on a broad range of topics.

Accounting Basics: “Variable-Rate Security” Fundamentals Quiz

### What primary benefit do variable-rate securities offer investors? - [x] Adaptability to changing interest rates - [ ] Higher fixed returns - [ ] Guaranteed principal protection - [ ] Tax-free interest payments > **Explanation:** The primary benefit of variable-rate securities is their ability to adjust interest payments with changing market interest rates, protecting investors from interest rate risk. ### Which of the following instruments is NOT an example of a variable-rate security? - [ ] Floating-rate notes (FRNs) - [x] Treasury bills - [ ] Variable-rate eurobonds - [ ] 90-day certificates of deposit (CDs) > **Explanation:** Treasury bills are short-term debt instruments issued by the government with fixed interest rates, whereas the other options are variable-rate securities. ### What is the common benchmark rate used for adjusting interest rates on variable-rate securities? - [ ] Prime rate - [x] LIBOR - [ ] Discount rate - [ ] Federal Reserve interest rate > **Explanation:** The LIBOR (London Interbank Offered Rate) is commonly used as a benchmark for adjusting interest rates on variable-rate securities. ### How often do interest rates on floating-rate notes (FRNs) typically adjust? - [ ] Annually - [x] Quarterly or semiannually - [ ] Biannually - [ ] Every decade > **Explanation:** Floating-rate notes typically adjust their interest rates quarterly or semiannually, aligning with changes in the benchmark rates. ### Which of the following best describes 90-day certificates of deposit (CDs)? - [ ] Long-term investment with fixed interest - [x] Short-term investment with variable interest - [ ] Long-term bonds with extended maturity - [ ] Investment with no interest risk > **Explanation:** 90-day certificates of deposit (CDs) are short-term investments that offer variable interest rates, making them adaptable to short-term rate changes. ### What risk is mitigated by investing in variable-rate securities? - [x] Interest rate risk - [ ] Credit risk - [ ] Default risk - [ ] Market risk > **Explanation:** Variable-rate securities help mitigate interest rate risk since their interest payments adjust in line with changes in market rates, unlike fixed-rate securities. ### Which feature distinguishes eurobonds with floating interest rates? - [ ] They are issued only in the US. - [ ] They have a fixed-interest rate. - [x] Interest payments vary with market rates. - [ ] They are exclusively short-term bonds. > **Explanation:** Eurobonds with floating interest rates are distinguished by their varying interest payments that adjust with changes in the market rates. ### Why do investors choose variable-rate securities in a rising interest rate environment? - [ ] For guaranteed fixed returns - [ ] To avoid any financial risk - [x] To benefit from increasing coupon payments - [ ] To secure long-term interest rates > **Explanation:** In a rising interest rate environment, variable-rate securities are appealing to investors because the coupon payments increase in line with market interest rates. ### How do variable-rate securities protect against interest rate drops? - [ ] They convert to fixed rates - [ ] They provide penalty interest - [x] They pass the reduced rate to the investors promptly - [ ] They come with a guaranteed minimum rate > **Explanation:** When interest rates drop, variable-rate securities adjust to reflect the lower market rates, which is promptly passed on to the investors. ### What is the interest rate risk impact on variable-rate securities compared to fixed-rate securities? - [ ] Higher interest rate risk - [x] Lower interest rate risk - [ ] No impact - [ ] Same risk as fixed-rate securities > **Explanation:** Variable-rate securities have a lower interest rate risk compared to fixed-rate securities because their interest payments adjust to reflect changes in the market interest rates.

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