Interest Rate Floor
An agreement between two parties in which the buyer pays the seller a premium.
What is an Interest Rate Floor?
An interest rate floor (IRF) is an agreement between two parties in which the buyer pays the seller a premium. In return, the seller will pay the buyer the difference between the specified floor rate and the lower variable rate, but only if the variable rate falls below the floor.
It is designed to protect investors against a fall in interest rates while allowing them to profit from a rise. They are often used in loan agreements and derivative contracts.
An interest rate floor is the opposite of an interest rate ceiling, which is the maximum interest rate permitted in a certain transaction.
IRFs are frequently used in the adjustable-rate mortgage (ARM) market. An ARM is a loan for a home with a variable interest rate. In the beginning, the loan will have a fixed interest rate, but after fixed periods of time, it will reset periodically.
IRFs are often purchased as part of a reverse interest rate collar, which involves simultaneously purchasing an interest rate floor and selling an interest rate cap.
When traders or borrowers want to understand their downside limit, they can use the floor as a guide. This can tell them the level of risk they are undertaking.
Key Takeaways
- An interest rate floor is the minimum interest rate that can be charged on a variable-rate loan or security, ensuring it won't fall below a specified level, regardless of market conditions.
- An interest rate floor protects lenders in a declining interest rate environment by ensuring they earn a minimum return on their investment or loan.
- In the context of ARMs, an interest rate floor sets the lowest rate that the mortgage interest can adjust to, ensuring that the borrower’s payments do not decrease below a certain point, thereby providing stability for the lender’s investment.
- While beneficial for lenders, an interest rate floor can limit the potential savings for borrowers when interest rates fall. Borrowers may not fully benefit from lower interest rates if the rate hits the floor.
Understanding Interest Rate Floors
Many market participants use IRFs to hedge against the risk associated with variable interest rate loans.
The buyer of this contract will be doing so to receive a payout should the interest rate fall below the negotiated rate. The buyer will be compensated for the lost interest when the interest rate falls; the seller will cover this compensation.
The buyer will have to pay a premium to the seller for this protection. This means even if the interest rate is above the floor, the buyer will have to pay a small premium, just like any other insurance contract. This is how the seller makes their money.
Deciding at what value the floor should be set is extremely important for both parties in this scenario. If the interest rate floor is set too high, then you may have the seller have to pay out compensation too often, and they will not be profitable.
If the floor is set too low, the buyer will continue to pay their premiums. However, if the interest rate never falls below the floor, they will never receive any compensation.
There are three common interest-rate derivative contracts:
- Interest rate floor
- Interest rate cap
- Interest rate swap
Interest rate floor and cap contracts are derivative products commonly bought on market exchanges.
Interest rate swaps are slightly different as they require two separate participants to agree on swapping an asset. This usually involves the exchanging of floating-rate debt for fixed-rate debt.
Instead of the normal exchange of balance sheet assets, interest rate floor and interest rate cap contracts can be used. This is an interest rate swap.
Downsides of an Interest Rate Floor
These are generally seen as positives for both parties involved, with the buyer being offered protection and the seller receiving premiums. However, if the IRF is miscalculated, then problems can begin to arise.
If the floor is set too low, the buyer will pay for premiums but not be offered compensation. This is because if the floor is too low, the rate will never fall below, and the seller will never have to pay out. In this scenario, the buyer is at a disadvantage.
If the floor is set too high, the seller must pay out compensation constantly. This is because if the floor is too high, the rate will always be below it, and the seller will have to pay compensation. In this scenario, the seller is at a disadvantage.
What Does an Interest Rate Floor Look Like?
IRFs are incredibly useful for investors who buy derivatives. They ensure that their returns will never fall below a given amount. They are crucial in hedging against the risk of falling interest rates.
Without them, investors would be at risk of diminishing returns if interest rates fell below a certain level.
Formula: For calculation
Payout = (X * R) - (X * Fr)
Where:
- X = Size of loan
- R = Interest rate
- Fr = Negotiated rate
Example: A lender in the United States is securing a floating-rate loan and looking to hedge against declining interest rates. This is to protect their returns.
If the lender buys an interest rate floor contract with a floor of 7%, the lender is protected if the R falls below 7%.
If the floating rate on a $10 million negotiated loan fell to 5%, the contract states that the payout would be $200,000. This is because
(($10 million x 0.07) - ($10 million x 0.05)) - $200,000
Interest Rate Floor FAQs
In finance, a floor generally refers to the lowest price or some other limit that can occur. This is agreed upon by controlling parties in the management of corporations. A floor can be applied in several scenarios, including prices, wages, interest rates, etc.
Some floors are regulatory constraints, whereas others act as guidelines. Minimum wage or interest rate floors are regulatory constraints, whereas underwriting floors act as guidelines.
A floor can also refer to the physical space in trading houses where brokers and traders will work. What used to be trading floors are now mainly replaced by trading desks since the revolution of computerization.
An interest rate cap is a type of interest rate derivative. The buyer receives payments at the end of each period when the interest rate exceeds the agreed strike price.
It is very similar to an interest rate floor, but instead of hedging against a fall in interest rates, it hedges against a rise in interest rates. Instead of protecting the lender like a floor, a cap will protect the borrower.
The LIBOR rate stands for the London Interbank Offered Rate. London banks use this benchmark interest rate to make short-term loans for other banks.
It is decided by the Intercontinental Exchange and is calculated by finding the average interest rate suggested by the panel banks.
A floor rate can be made in association with a LIBOR rate. For example, a loan can be created with a rate of 1 month LIBOR + 1%, a floor, and a ceiling of 3% and 5%, respectively.
If the 1-month LIBOR rose to 4.5%, then the rate would be 5.5% which is above the 5% ceiling. Therefore the loan would be evaluated at 5%. Similarly, if the 1-month LIBOR fell to 1.5%, the rate would be 2.5%, below the floor of 3%, so the loan would be evaluated at 3%.
If the 1-month LIBOR was 3.5%, the rate would be 4.5%; as this is within the floor and ceiling parameters, the loan would be evaluated at 4.5%.
Researched and authored by Seb Bailey | LinkedIn
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