Interest Rate Floors

 

What is a Floor?

 

An Interest Rate Floor is an agreement by one party to make payments to another party when a reference variable rate (i.e. CDOR) falls below a "floor" level.  As with a Cap, a Floor is a series of 3-month options, each independent of each other.

 

Investors use Floors to secure a minimum level of return on their investment.  The Floor, in exchange for a premium, ensures that the purchaser receives no less than the floor level on his or her investment.   On the other hand, issuers use Floors to reduce the initial cost of financing and/or to finance the purchase of rate protection on a loan (i.e. a Cap).  On its own, the sale of a Floor generates current income in exchange for the potential benefit of lower variable reference-rates - the Floor limits the benefits associated with the variable interest rate exposure without reducing the associated risks (i.e. an increase in rates).

 

Table 1: Cash Flows generated by Interest Rate Floors

 

In this paper we focus on the combination of a Cap and a Floor, which is commonly referred to as an Interest Rate Collar.  More specifically, we concentrate on the simultaneous purchase of a Cap and sale of a Floor by an issuer who wishes to acquire some interest rate protection on an outstanding loan and who is willing to give up some of the advantages associated with a fall in variable rates.  In other words, the Collar restricts the increase in variable rates while limiting potential cost savings associated with a decline in rates.  Fluctuations of the reference variable rate are thus contained within a tight range.

 

In a case where the purchase cost of the Cap is completely offset by the premium generated by the sale of the Floor,

the debtor is in possession of a costless Collar.

 

How does this work?

 

There are two elements to consider when setting the strike levels on the Collar.

 

Once the strike levels are set, the issuer buys a Cap and sells the Floor.  This strategy could generate an inflow or outflow of cash since the premiums on the Cap and Floor might not perfectly offset each other.  Alternatively, the issuer could determine the strike level on the Cap and solve for a Floor level that would generate a premium equal to that of the Cap.

 

For example, a client might decide on a 5.00%, 3-year Cap on a $5 million loan and is willing to give up some of the benefits of a potential decline in rates.  The premium on the Cap is evaluated at $39,000.  To offset this cost, the same client sells a Floor at 3.00% for $35,000.  The total initial outlay for this transaction is $4,000. 

 

The client could have very well sold a Floor with a strike level of 3.20% generating a premium of $39,000 - but would have given up an extra 20 bps on the benefits of a lower variable reference-rate. Graph 1 illustrates the interest payments on a loan capped at 5.00% and "floored" at 3.00%.

 

Graph 1: Interest Payments on a loan capped at 5.00% and "floored" at 3.00%

 

Table 2: Cash Flows on a loan capped at 5.00% and "floored" at 3.00%

Periods	Reference Floating Rate (A)	Interest Rate paid on loan (B=A+0.50*)	Rate received on the Cap (C=A-5.00; if A>5)	Rate paid on the Floor (D=3.00-A; if A<3)	Resulting Interest Rate (E=B-C+D)
1	2.50	3.00	0.00 .	0.50	3.50
2	2.75	3.25	0.00	0.25	3.50
3	3.25	3.75	0.00	0.00	3.75
4	3.75	4.25	0.00	0.00	4.25
5	4.50	5.00	0.00	0.00	5.00
6	5.50	6.00	0.50	0.00	5.50
7	5.75	6.25	0.75	0.00	5.50
8	5.25	5.75	0.25	0.00	5.50

(*Table 2 assumes a 50-bp Stamping Fee on the loan facility.)

 

As demonstrated in table 2, the Cap guarantees that the interest rate paid on the loan will always be lower than the strike level on the Cap, plus the Stamping Fee on the loan facility.  However, because of the sale of a Floor, the interest rate paid on the loan will never be less than the Floor level, plus the Stamping Fee.