What it means
Suppose a bank makes loans at a floating rate and funds itself with fixed-rate deposits. If market rates drop sharply, its income falls while its costs do not, and a floor can compensate for the difference.
The contract is built from a series of individual options, called floorlets, one for each interest period. On each date, the reference rate, such as a published benchmark rate, is compared with the strike.
If the rate is lower than the strike, the seller pays the difference, applied to an agreed notional amount, which is the amount on which interest is calculated and not a sum that changes hands. The buyer's loss is limited to the premium, and the benefit can be large if rates collapse.
The seller, by contrast, collects the premium but takes on the risk of paying out if rates fall. Floors are often combined with a cap, which pays if rates rise above a level, to create a collar.
A borrower who buys a cap and sells a floor can cut the cost of the protection, giving up the benefit of very low rates in exchange. Floors also appear inside loans and bonds.
A floating-rate loan may have a floor in its terms, so the rate paid by the borrower cannot fall below a minimum even if the benchmark does, and the lender is effectively holding a floor. The price of a floor depends on how far the strike is from current rates, the length of the contract, and expected volatility.
A floor with a strike above current rates costs more, because it is more likely to pay out.
In practice
Real-world examples.
Example
A regional bank holds $500,000,000 of floating-rate loans and worries that rates will fall. It buys a floor to guarantee that its interest income will not drop below a minimum level.
Example
A pension fund holds floating-rate notes and expects the central bank to cut rates. It buys a floor so that, if rates drop, the compensation from the contract offsets the lower coupons.
Example
A property company with a floating-rate loan buys a cap to protect against rises, and sells a floor to help pay for it. If rates fall below the floor strike, the company pays the difference, but the cost of protection is lower.
Formula
Calculation
Floorlet payoff = Notional amount x Maximum of (Strike rate - Reference rate, 0) x Days in period / 360
A bank buys a floor with a notional amount of $10,000,000 and a strike rate of 3%, covering quarterly periods. On one reset date, the reference rate is 2%. The payoff is 10,000,000 x (3% - 2%) x 90 / 360 = 10,000,000 x 0.01 x 0.25 = $25,000. If the reference rate were 3.5% instead, the payoff would be zero, and the bank would have lost only the premium, for example 0.20% of the notional, or $20,000. Over a year of four quarterly resets at a 2% reference rate, the total payoff would be 4 x $25,000 = $100,000, which is five times that premium.Case study
Seen in the real world.
Greystone Savings is an illustrative, fictional lender with $200,000,000 of floating-rate mortgages that reset every three months, funded partly by fixed-rate deposits. The treasurer feared that rates would drop sharply during a recession and cut the bank's income.
She bought a two-year floor with a strike of 2.5% on a notional amount of $100,000,000, paying a premium of $350,000. Over the next year the reference rate fell to 1.5% and stayed there, and each quarter the floor paid 100,000,000 x 1% x 0.25 = $250,000.
Over four quarters the fictional bank received $1,000,000, which more than covered the premium of $350,000 and softened the fall in income. The illustrative lesson is that a floor is insurance, and it pays off in exactly the conditions that the buyer is worried about.
Watch out
Common mistakes.
- Thinking the notional amount is paid between the parties, when it is only used to calculate the interest payment.
- Forgetting the premium, which is a real cost that reduces the benefit of the floor if rates do not fall and is lost whether or not the floor ever pays.
- Confusing a floor with a cap, when a floor protects against falling rates and a cap protects against rising rates.
Questions
People also ask.
Who buys an interest rate floor?
Lenders, investors and anyone who receives floating-rate income and wants a minimum return typically buy floors. Sellers are usually banks and other institutions that are comfortable taking the opposite risk.
What is the difference between a floor and a floorlet?
A floor is the whole contract, while a floorlet is the single option for one interest period within it.
How does a floor differ from a fixed-rate loan?
A fixed-rate loan locks in the rate completely, while a floor allows the holder to benefit if rates rise but be protected if they fall.
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