The details of interest rate floor instrument are given in Table 10.2 for the purpose of this illustration.

Recording the trade—contingent

This interest rate floor agreement is based on making a payment to the buyer of the instrument when a reference rate falls below the specified floor rate, the length of the period and the contract’s notional amount. As this is a notional amount and no physical exchange of money takes place, the investor has to pass an off balance sheet entry to record the transaction as shown in Table 10.3.

Table 10.3 At the inception of the interest rate floor contract


Account for the premium on the trade

The cost of the floor instrument on purchase is known as the non-refundable premium. The premium for an interest rate floor depends on the floor rate that the investor wants to get when compared to current market interest rates. The premium for an interest rate floor also depends on several other factors as this type of contract is very similar to that of an option contract, where the premium is based on the strike interest rate (floor rate), current interest rate, time to maturity of the contract, volatility—both historical and implied. When the contract is purchased then a premium is paid and when the contract is sold a premium is received. In a to pay contract a premium is received and the investor will have ...

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