Interest rate floors compare to interest rate caps in the same way that puts compare to calls. They are OTC derivatives that protect the holder from declines in short-term interest rates by making a payment to the holder when an underlying interest rate (the “index” or “reference” interest rate) falls below a specified strike rate (the “floor rate”). Floors are purchased for a premium and typically have maturities between 1 and 7 years. They may make payments to the holder on a monthly, quarterly or semiannual basis, with the period generally set equal to the maturity of the index interest rate.
Each period, the payment is determined by comparing the current level of the index interest rate with the floor rate. If the index rate is below the floor rate, the payment is based upon the difference between the two rates, the length of the period, and the contract’s notional amount. If the index rate is not below the floor rate, no payment is made for that period.
In US markets, if a payment is due on a USD Libor floor, it is calculated as
For example, Exhibit 1 illustrates a 3-year, USD 200MM notional floor with 6-month Libor as its index rate, struck at 3.5%. The exhibit shows what the floor’s payments would be under a hypothetical interest rate scenario.
Floors are used by purchasers of floating rate debt who wish to protect themselves from the loss of income that would result from a decline in interest rates. End users may also short a floor against a cap to construct an inexpensive or costless collar.
Just as a cap can be thought of as a series of caplets, a floor can be thought of as a series of interest rate options called floorlets. Floors are priced by valuing the individual floorlets and summing the values. The Black ’76 option pricing formula is the market convention for quoting implied volatilities for floors.
Floors are usually quoted with an up-front premium. If they are quoted with an implied volatility, it is typically with a flat implied volatility across all floorlets.