This thesis suggests a convenient tool for the practitioners to value Dual Index floating rate notes with Black-Derman-Toy model(1990) and introduces hedging method. In this study, we can find the fair value of Dual Index floating rate notes reflecting the credit risk calculated by Jarrow and Turnbull ’s no-arbitrage model(1995). To value these bonds, we should construct a binomial interest rate tree by using the technique of forward induction developed by Jamshidian(1991). The result of the empirical analysis shows that the theoretical values for selected bonds are higher than the issue prices, even though we considered the credit risk. So one can expect that the investment in these bonds will be profitable.
If we do not prepare for an unfavorable movement of the future interest rate after investing in Dual Index FRN, we may experience the unexpected loss. So hedging will be needed to hedge this risk under an uncertain circumstance. To reduce interest rate risk, we can use the yield curve swap as hedging method and transform a floating-rate coupon into a fixed-rate one.
