Floors in Finance

In finance, a “floor” refers to a derivative contract that provides protection against a decline in interest rates below a specified level. It’s essentially a series of put options on a benchmark interest rate, such as LIBOR or SOFR. The buyer of a floor pays a premium upfront and, in return, receives payments if the reference interest rate falls below the agreed-upon floor rate.

How Floors Work

Imagine a business has a loan with a floating interest rate tied to LIBOR. If LIBOR rises significantly, the business’s interest expense increases. To mitigate this risk, the business can purchase a cap, which protects against rising rates. Conversely, if LIBOR falls significantly, the lender’s income from the loan decreases. To protect their downside, the lender can purchase a floor.

Specifically, a floor consists of a series of “floorlets.” Each floorlet corresponds to a specific period (e.g., a quarter or a year) and a strike rate (the floor rate). If, at the end of a floorlet’s period, the reference interest rate is below the strike rate, the floor buyer receives a payment. The payment is typically calculated as the difference between the strike rate and the reference rate, multiplied by the notional principal amount and the period’s length (expressed as a fraction of a year).

For example, suppose a lender buys a floor with a strike rate of 2% on a $1 million notional principal, and LIBOR falls to 1.5% during a specific quarter. The lender would receive a payment of (2% – 1.5%) * $1,000,000 * (1/4) = $1,250 for that quarter.

Key Characteristics

• Strike Rate: The predetermined interest rate below which the floor provides protection.
• Notional Principal: The hypothetical amount used to calculate the payment.
• Reference Rate: The benchmark interest rate to which the floor is linked (e.g., LIBOR, SOFR).
• Floorlets: Individual option-like components that make up the floor, each corresponding to a specific period.
• Premium: The upfront cost paid by the buyer to the seller of the floor.

Purpose and Applications

Floors are primarily used for hedging interest rate risk. They’re a valuable tool for:

• Lenders: Protect their income from floating-rate loans when interest rates decline.
• Investors: Hedge portfolios containing floating-rate securities.
• Financial Institutions: Manage their overall interest rate exposure.

By purchasing a floor, these entities can effectively establish a minimum return on their assets or loans, providing certainty in a volatile interest rate environment.

Relationship to Caps and Collars

Floors are closely related to interest rate caps. While a floor protects against falling rates, a cap protects against rising rates. A “collar” combines a cap and a floor. For example, a borrower might buy a cap to protect against rising rates and simultaneously sell a floor to offset the cost of the cap. This creates a range within which the borrower’s interest rate will fluctuate.

Valuation

The price of a floor is influenced by several factors, including the strike rate, the current level of interest rates, the volatility of interest rates, and the time to maturity. Various pricing models, such as the Black-Scholes model adapted for interest rate options, are used to determine the fair value of floors.