A fixed-rate instrument has an interest rate that is set at the contract inception and remains constant throughout the life of the instrument.
• The value of a fixed-rate instrument is the present value of its expected cash flows
• Most residential mortgages are fixed-rate instruments
A floating-rate instrument has an interest rate that changes throughout the life of the instrument.
• The rate is usually tied to an index, such as the 1-month LIBOR.
• The “reset date” or “rate fixing date” is when the new rate is determined for calculating future interest (a floating-rate instrument that resets quarterly would thus have a new interest rate every 3 months)
• Many commercial loans, credit cards, and home equity lines of credit are floating-rate instruments
Valuing a floating-rate instrument can be difficult because the amount of all future cash flows is not known at inception. One way to value the instrument is to predict what future interest rates will be at the reset dates (either by calculating implied forward rates or using a forecasting model) and then discount the expected cash flows as you would do with a fixed-rate instrument.
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