Interest Rate Floor

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Interest Rate Floor</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"><p class="word_list"> <a href="#floorlets">floorlet</a><p class="word_list"> <a href="#Interest rate floor">interest-rate floor</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="left" id="table5"> <tr> <td width="300" height="14"><font size="2"> </font><font size="4"> </font></td> <td width="9" height="14"></td> </tr> <tr> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p class="body"><b><a name="Interest rate floor">Interest rate floors</a></b> compare to <a href="../articles/cap.htm">interest rate caps</a> in the same way that <a href="../articles/option.htm">puts</a> compare to <a href="../articles/option.htm">calls</a>. They are <a href="../articles/exchange_traded.htm">OTC</a> <a href="../articles/derivative_instrument.htm">derivatives</a> 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 <a href="../articles/option.htm">strike</a> rate (the "floor rate"). Floors are purchased for a <a href="../articles/time_value_and_intrinsic_value.htm">premium</a> 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.</p> <p class="body">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 <a href="../articles/notional_amount.htm">notional amount</a>. Otherwise, no payment is made for that period. In US markets, if a payment is due on a <a href="../articles/currency_codes.htm">USD</a> <a href="../articles/libor.htm">Libor</a> floor, it is calculated as</p> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" height="36" id="table6"> <tr> <td width="100%" align="center"> <img border="0" src="../formulas/ex1_payment.gif" width="339" height="44"></td> <td width="5%" align="right">[1]</td> </tr> </table> <p class="body">For example, Exhibit 1 illustrates a 3-year, USD 200<a href="../articles/mm.htm">MM</a> notional floor with 6-month Libor as its index rate, struck at 5.5%. The exhibit shows what the floor's payments would be under a hypothetical interest rate scenario. </p> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="350" cellpadding="0" id="table7"> <tr> <td> <p class="exhibit_header"><span class="exhibit_header">Example: Floor Payments</span><br> <span class="exhibit_subheader">Exhibit 1</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td><img border="0" src="../images/ex1_floor.gif" width="300" height="128"></td> </tr> <tr> <td> <p class="exhibit_legend">Payments made under a hypothetical interest rate scenario by a 3-year USD 200MM notional floor linked to 6-month USD Libor with strike rate of 5.5%. Values for the index rate are 6.75%, 5.25%, 6.25%, 4.50%, 5.00%, 6.75%. These result in payments of USD 0MM, USD .25MM, USD 0MM, USD 1MM, USD .5MM, and USD 0MM.</td> </tr> </table> </center> </div> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="right" id="table8"> <tr> <td align="right" width="9" height="10"></td> <td width="336" height="10"> <font size="2"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body">Floors are used by purchasers of <a href="../articles/floater.htm">floating rate debt</a> who wish to protect themselves from the loss of income that would result from a decline in interest rates. End users may also <a href="../articles/short_sale.htm">short</a> a floor against a cap to construct an inexpensive or costless <a href="../articles/options_spread.htm">collar</a>.</p> <p class="body">Just as a cap can be thought of as a series of <a href="../articles/cap.htm">caplets</a>, a floor can be thought of as a series of interest rate options called <b><a name="floorlets">floorlets</a></b>. Floors are priced by valuing the individual floorlets and summing the values. The <a href="../articles/black_1976.htm">Black '76</a> option pricing formula is the market convention for quoting <a href="../articles/volatility.htm">implied volatilities</a> for floors. </p> <p class="body">Floors are usually quoted with an up-front premium. 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