Interest Rate Floor

Characteristics 

A floor is a series of sequentially maturing European style put options that protect the purchaser from a fall in a floating rate index, usually =//LIBOR//= below a predetermined level. The purchaser has the right to receive a periodical cashflow equal to the difference between the market rate and the strike.

The situation

A firm has cash resources, and they think will have these funds for some time. They do not want to negotiate a fixed rate of interest, because they think interest rates may rise, but they do want to guarantee a certain minimum return.

The product

An Interest-Rate Floor offers an ideal solution for this problem. It guarantees a specified minimum rate of return on the deposit. If floating interest rates fall below this level, they will be paid compensation by the issuing bank. At the same time, there is full benefit from higher interest rates.

The solution

At each reset date, if floating interest rates are above the floor level, there is the option to accept the market rate. On the other hand if interest rates at that point are lower than the floor level, the floor will protect the company. In this way, the firm will always achieve the 'floor' rate. The floor level refers to the market rate for funds - generally the LIBOR rate for the appropriate period. Bank’s can tailor Interest-Rate Floors to suit any client's needs.

The benefits

The floor will give a guaranteed minimum return on cash holdings.

The floor will give the freedom to take advantage of higher interest rates.

If the cash balance is run down, it is possible to sell the bank back the floor and receive some value.

Features

The firm can arrange an Interest-Rate Floor with any bank. It doesn't have to be the one where your cash is deposited or expected to be deposited.

Banks provide floors on all the major traded currencies.

Banks can arrange Interest-Rate Floors for different maturities, typically for maturities up to 5 years.

Banks usually pay compensation at the end of each relevant LIBOR period when interest rates fall below the floor.

A firm can pay the premium for the Interest-Rate Floor up front or over the life of the contract.

The premium paid will depend on:

the guaranteed rate and the swap rate;

how long you want the floor for; and

how often interest rates are changing.

The general characteristics and market practices are the same as those for caps.


An Interest Rate Floor is a contract that guarantees a minimum level of Libor. A Floor can be a guarantee for one particular date, known as a Floorlet. A series of Floorlets, or Floor can extend for up to 10 years in most markets. In return for making this guarantee, the buyer pays a PREMIUM. Floors generally guarantee a minimum level of either 3 or 6 month Libor or whatever the prevailing floating rate index is in the particular market. The clients maximum loss on a Floor transaction is the premium. After purchasing the Floor, the buyer can make "claims" under the guarantee should Libor be below the level agreed on the Floor on the settlement dates. A Floor is NOT a continuous guarantee, it is only date specific. This means claims can only be made on specified dates. These dates are selected by the purchaser.

Should the buyer never be required to make a claim under the Floor, the option will expire worthless. At settlement a Floorlet has a profit profile as follows:

When Libor is above the strike 8.50%, the floorlet has no value. Claims will only be made when Libor is below 8.50%. The break even is therefore the strike less the premium.

PRICING/VALUE

The Floor price (premium) has two major components:

(a) Intrinsic Value

When the strike of the Floor is HIGHER than the Implied Forward rate, the Floor is said to have Intrinsic Value. The Implied Forward is the market expected rate, and therefore if we seek a guarantee of a higher rate, the expected value of the Floor is positive, so it has Intrinsic Value. A Floor that has a strike higher than the implied forward (i.e. has positive Intrinsic Value), is described as IN THE MONEY. A Floor with negative Intrinsic Value, is described as OUT OF THE MONEY. A Floor set at the implied forward is described as AT THE MONEY FORWARD. A Floor set at the current Libor level is AT THE MONEY SPOT.
  
Higher Intrinsic Value leads to a higher premium.

The relevant Implied Forward is the Swap rate for the period of the Floor or the FRA rate for a Floorlet.

(b) Time Value

The Floor is a guarantee of a future rate. The implied forward rate will change over time as the market changes its view of future rates. The price of the Floor will therefore depend on the likelihood that the market will change its view. This likelihood of change is measured by volatility. An instrument expected to be volatile between entry and maturity will have a higher price than a low volatility instrument. The volatility used in calculating the price should be the expected future volatility. This is based on the historic volatility.
  
As time goes by, the volatility will have less and less impact on the price, as there is less time for the market to change its view. Therefore, in a stable market, the passing of time will lead to the Floor FALLING in value. This phenomenon is known as Time Decay. This increases in severity as we get closer to maturity.

REVERSING FLOORS

Bought Floors can be sold at any time. The value of the Floor will depend on the same factors above, Intrinsic value and Time Value. The Intrinsic Value is calculated by comparing the strike with the Implied Forward levels . The Time Value will depend on the amount of time left before maturity (less time less value) and the volatility of the underlying instrument ( high volatility higher value)

TARGET MARKET

Floors have two major Target Markets:

(a) Investors - For investors who own Floating Rate Notes or any form of investment that resets against Libor, Floors offer an ideal method of providing a minimum return. Here the Floor is used like an insurance policy. The buyer purchases insurance against Libor falling below a certain level and pays a premium.

(b) Speculators - Investors who believe short term rates will fall can buy a Floor. They will profit when rates are below this level and will limit loss to the cost of the premium.

STRATEGY

The further the strike is set OUT OF THE MONEY, the cheaper the Floor as the probability of payout is less, therefore the Floor is considered to be more LEVERAGED. As rates fall the Floor will increase in value as it becomes closer to the money. It is therefore an interesting strategy to buy OUT OF THE MONEY floors for a small premium which will increase in value dramatically ( due to the leverage) as rates fall. The Floor can then be sold. This is a trading strategy rather than buy and hold.

Sophisticated Investors may like to SELL Floors. This is also known as writing Floors. In this case the Investor is PROVIDING the guarantee and therefore has an unlimited loss potential. The profit from this strategy is limited to the premium earned and will occur when there are no claims against the Floor.

ADVANTAGES

DISADVANTAGES

This can lead to a Floor losing value despite rates falling in line with expectation.

PRODUCT SUITABILITY

Bought Floors: Simple Defensive

Sold Floors : Simple Aggressive

SUMMARY

Floor applications
The interest rate floor market is considerably smaller than the cap market. Interest rate risk management tend to centre on the effectively funding long term assets with short term liabilities. Floors do have significant value however in a number of market scenarios.

A Bank with a portfolio of floating rate debt will wish to hedge any potential drop in short term interest rates by purchasing a Floor.

An institution receiving a prime rate related return will seek to protect itself from any fall in the rate by the purchase of a floor.

An institution issuing floating rate debt at LIBOR + a premium, may lower its funding cost by selling a floor to investors concerned about potential falls in short term interest rates.

An institution issuing commercial paper for short term financing may wish to lower its funding costs in an interest rate environment where rates seem unlikely to fall significantly. If interest rates do fall in the future the institution should be able to borrow at lower rates and take advantage of the additional business activity. The premium received will reduce funding costs now without significantly impacting overall earnings if interest rates do continue to fall.

 Flooridor
An uncommon strategy where the cost of the purchase of a floor is offset by the sale of another floor with a lower, further out of the money, strike.

 Floortion

An option on a Floor. Complicated to price and hedge these compound options rarely appear in the Broker market.