Interest Rate Floor

An interest rate floor places a minimum value (floor strike) on a floating rate of interest on a specified notional principal amount for a specific term. The buyer of the floor uses the floor contract to limit his minimum interest rate. The seller of the floor accepts a minimum on the interest rate it will pay in return for the floor premium. Often the floor premium is used to offset the cost of a purchased interest rate cap. If the floating rate drops below the floor strike, the floor provides for payments from the seller to the buyer for the difference between the floor strike and the floating rate.
The floor premium charged by the seller depends upon the market's assessment of the probability that rates will move through the floor strike over the time horizon of the transaction. If the yield curve is upward sloping, a shorter term (two years vs. five years) and/or a lower strike (4.0% vs. 5.0%) will result in a lower floor premium. Normally, the floor premium for the entire life of the floor is paid two days after the trade date. The floor premium takes the form of an up front fee that is usually expressed in basis points as a percentage of the notional principal amount.
Any period that the floor is in the money (floating rate
Credit exposure in an interest rate floor is one-way. The buyer of the floor is exposed to the seller for potential payments under the floor over the life of the transaction. The buyer of a floor should be cognizant of the credit-worthiness of its counterparty. At the Bank formal credit approval is required before purchasing an interest rate floor.
EXAMPLES OF PAYMENT FLOWS If floor strike If floating rate notional principal x (floor strike - floating rate) x actual days/360 The floor buyer’s effective interest rate is equal to the higher of the floating rate or the strike less, in each case, the amortized cost of the floor premium.
TYPICAL CHARACTERISTICS

Start date: Spot or Forward
Floating Rate Indexes: All Major Fixed Income Indexes

Term: Up to 10 Years
Structure: Bullet, Amortizing or Accreting
Strike(s): Constant or at varying Levels
Reset Frequency: Semi-Annually, Quarterly, Monthly, or Daily
Setting : Discreet or Average

TYPICAL FLOOR APPLICATIONS
Liability Management

Situation 1: A corporation has a high degree of fixed rate debt and wants to increase its exposure to floating interest rates, but limit the risk of the increased exposure.
Solution: The corporation purchases an interest rate floor at an out of the money strike level. The company's total exposure would be the premium payment for the floor, and the company benefits if rates drop below the floor strike level.

Situation 2: A corporation has a debt structure that is 50% fixed and 50% floating. The company feels short-term rates are going to rise, but is uncertain about the degree of the increase. The company does not want to fix additional debt through a swap.
Solution: The corporation can sell an out of the money interest rate floor. The company collects the premium, but limits the benefit to a decline in interest rates.

Asset Management

Situation 1: An investor holds a floating rate note (LIBOR + spread). The investor feels rates are going to rise and wants to enhance the yield on the floating rate note.
Solution: The investor sells an out of the money interest rate floor. The investor collects the premium that enhances the yield on the note at current rate levels. However, if interest rates decline, the investor would have to pay out under the floor decreasing the yield on the note.

Situation 2: An investor holds a floating rate note (LIBOR + spread). The investor feels rates are going to fall and wants to enhance the yield on the floating rate note.
Solution: The investor buys an out of the money interest rate floor. The premium payment for the floor decreases initially the investor's yield, but if rates fall the investor's yield will be greatly enhanced. If interest rates rise, the investor's only cost is the floor premium.