INTEREST RATE FLOORS—DESCRIPTION OF THE PRODUCT
Interest rate floors are a form of interest rate derivatives. These are over-the-counter derivatives that protect the holder from declines in short-term interest rates by making a payment to the buyer when an underlying reference rate falls below a specified rate, known as the floor rate or the strike rate. The holder of a floor instrument pays a premium to get protection from a decline in interest rates. For each period, the payment is determined by comparing the current level of the reference rate with the agreed floor rate. If the reference rate is below the floor rate, the payment is calculated with reference to the difference between the two rates, the length of the period, and the notional amount of the contract. Then the buyer of the instrument receives the interest and the writer of the instrument makes the payment. If the current interest rate is above the strike interest rate then no payment is made for that period.
Interest rate floor—to pay
Again interest rate floors are of two types—the first type being “to pay.” This means that for receiving an agreed premium the buyer of this type of instrument agrees to compensate the seller of the instrument on the pay date any interest falling below the floor rate, if the benchmark interest rate is below the floor rate on the reset date. The premium is computed like any other option premium based on some mathematical model that takes into account several factors including the strike ...