Interest Rate Floor

In this paper we will analyze floor or interest rate floor. It is a kind of Over the Counter derivative. Floor value can be assumed as a series of individual interest rate options, called floorlets. We will also provide the mathematical interpretation of floor.
The end users of commodities use floor to establish a low price “Collar”. Interest rate floors, or simply floors, are basically Over the Counter derivatives, which provide protection against the fall of short-term interest rates to the holders.

When an underlying rate comes down below a certain rate, which is called the floor rate, the floors make the payment to the credit holders. Interest rate floors are usually purchased for a premium and its maturities range between 1 to 7 years. Floors pay to the holders on a quarterly or monthly or half yearly basis.

The period is normally set on the same level of the index rate’s maturity. The purchasers of Floating Rate Debt who want to combat the fall of interest rates use floors. The fall of interest rate may result in low incomes. The end user of commodities also use floor to build an inexpensive “Collar”.
Floor can be represented through a series of interest rate options, which is termed as Floorlets. Calculating the value of each floorlets and then adding those values determine its value. However, floors are quoted normally with an “up front premium”.
Mathematical Interpretation:
The amount of payment is calculated by comparing the floor rate with the present index interest rate level. If the index rate gets lowered than the floor rate, then the amount will be calculated on the basis of the difference between the length of the period and notional amount of the contract.

In the United States of America, the floor is mathematically interpreted in the following way:

Amount of Payment = (f – i) * {(period)/360 * A)}
Where f = Floor Rate,
i = Index Rate,
A = Notional Amount.

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Last Updated on : 1st August 2013

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