Interest Rate Floor
AdvancedAn interest rate floor is a derivative contract that pays the holder when a floating interest rate falls below a set level, called the floor rate, protecting lenders and investors against falling interest income.
A floor is the mirror image of a cap. The buyer pays a premium, and at each payment date, if the reference rate is below the floor rate, the seller pays the difference on the notional amount for that period.
For example, an investor holding 20,000,000 of floating-rate assets buys a floor at 2%. If the reference rate falls to 1.25% for a quarter, the floor pays 0.75% on 20,000,000 for a quarter of a year, or 37,500.
A floor is made up of a series of individual options called floorlets. Floors are used by banks, investors and lenders who earn floating-rate income and want protection if rates fall.
Many floating-rate loans also include a built-in floor, which sets a minimum interest rate the borrower must pay, often by setting a minimum level for the benchmark rate. Combining a bought cap with a sold floor creates an interest rate collar, which reduces the cost of protection but limits the benefit if rates fall.
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