We have a three-year FRN with a coupon of three-month MRR + 1.25%. Given an expected strong economic recovery, a rise in MRR over the next three years is expected along with an improvement in the FRN issuer’s creditworthiness. Which of the following credit spread measures does she expect to be the lowest as a result?
Discount Margin, Quoted Margin, and Zero Discount Margin.
Answer in text is Zero Discount Margin. Why? I thought Discount Margin should decline since creditworthiness has improved, so DM should be the lowest, isnt it? What am I getting wrong here?
DM and Z-DM are basically the same, albeit the former is a spread over spot rates and the latter a spread over forward rates. Assuming an upward sloping term structure, the Z-DM must be lower. If you think about it, the forward curve is above the spot curve so forward rates must be higher, therefore to derive the same price you must apply a lower spread.