An interest rate floor is the lower range of rates that is agreed upon, when a floating rate loan product is purchased from a lending institution. They are also found in many derivative products and are often used when calculating and projecting risk.
When traders or borrowers seek to understand their downside limit, the interest rate floor can help them understand the level of risk they are taking on and the type of hedge they may wish to take on.
Adjustable-rate mortgages are a common instrument utilized by borrowers in the U.S. The interest rate floor instrument helps protect lenders from falling interest rates and secure a base minimum interest accruement on their loan principal.
Interest rate floors are often purchased as a part of an interest rate collar. They are part of a hedging strategy that may be executed in order to protect against fluctuations in the market and more accurately forecast cash flows for presentation to stakeholders and investors.
Interest rate floors are generally a contract between two parties that provide a floor on floating-rate payments.
When traders or borrowers seek to understand their downside limit, the interest rate floor can help them understand the level of risk they are taking on and its limits.
Understanding at what value the floor should be set is pivotal to utilizing an interest rate floor effectively.
Understanding Interest Rate Floors
Interest rate floors are also instruments that consist of a series of European put options on interest rates. They are called floorlets. The buyer of the instruments receives payments at the end of each predetermined period where the interest rate falls below the strike price of the option.
When purchased, an upfront premium is paid by the buyer to the seller. The interest rate floor will pay off according to the diagram below:
What Does an Interest Rate Floor Look Like?
Let us pretend for an instance that you are a corporate banker looking at underwriting a sizable loan for one of your larger business clients. They’ve requested to select a variable rate loan, believing interest rates will likely drop for the period that they will be paying back the principal and interest.
Your internal strategy team at your bank agrees that this is a possible scenario. You then decide that in order to mitigate against this possibility, you will hedge your loan by buying an interest rate floor option. This will protect you from any lost interest income if interest rates fall below the interest rate floor.
Downsides of an Interest Rate Floor
When lending large sums of money with variable rates, there are limited downsides to purchasing an interest rate floor contract. Their protection is a useful form of insurance most lenders would be prudent not to ignore. However, if the floor is set to low, then the premium paid for this instrument may be considered a waste.
Understanding at what value the floor should be set is pivotal to utilizing an interest rate floor effectively. Without doing so, you may find yourself purchasing these types of instruments at ineffective rates relative to market fluctuations and possible interest rate outcomes. As such, a broader understanding of the interest rate market is required in order to better understand how to construct this type of hedge.
CFI offers the Certified Banking & Credit Analyst (CBCA)® certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
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