Why does a floating rate note have an effective duration near zero and what are the exceptions?

Question

AcadiFi · Accepted Answer

A floating rate note's coupon resets periodically to a reference rate plus a fixed spread. At each reset date, the FRN's price returns to approximately par because its...

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**Why Duration Is Near Zero:**

Consider a 5-year FRN that resets quarterly. At each reset, the coupon adjusts to the new 3-month rate + spread. The investor effectively holds a series of 3-month instruments.

**Effective Duration ≈ Time to Next Reset ÷ 2**

For a quarterly-reset FRN: Duration ≈ 0.25 / 2 = **0.125 years** (essentially zero)

**Worked Example -- Lantern Capital FRN (fictional)**

Lantern issues a 5-year FRN paying 3-month SOFR + 80 bps, resetting quarterly. Currently 45 days until next reset.

| Metric | Fixed-Rate 5yr Bond | Lantern FRN |
|---|---|---|
| Maturity | 5 years | 5 years |
| Modified Duration | ~4.2 years | ~0.12 years |
| Price impact of +100 bps | -4.2% | -0.12% |
| Interest rate risk | High | Negligible |

**When FRN Duration Is NOT Near Zero:**

1. **Between reset dates**: Duration is the remaining time until next reset (max = reset frequency). Immediately after reset, duration = full reset period; immediately before, it's ~0.

2. **Credit spread changes**: While the reference rate risk is near zero, the FRN is still exposed to credit spread risk. If Lantern's creditworthiness deteriorates, the fixed +80 bps spread becomes inadequate, and the price drops. This spread duration can be close to the maturity of the FRN.

3. **Rate caps/floors**: If the FRN has a cap (maximum coupon rate) and rates rise above the cap, the FRN starts behaving like a fixed-rate bond and duration increases toward maturity.

4. **Rare reset frequencies**: Annual-reset FRNs have up to 1 year of duration between resets.

| Risk Type | Measured By | FRN Exposure |
|---|---|---|
| Interest rate risk | Effective duration | ~0 (resets eliminate) |
| Credit spread risk | Spread duration | ~Equal to maturity |
| Cap/floor risk | Effective duration (above cap) | Can approach maturity |

The critical exam insight: FRNs neutralize interest rate risk but retain full credit spread risk. Investors who buy FRNs to avoid rate risk still face potential losses if credit spreads widen.

Why does a floating rate note have an effective duration near zero and what are the exceptions?

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