Terrastone

Treasury

Interest Rate Floor

Purpose Of Interest Rate Floor

The purchase of a Floor option will allow the investor (the depositor) to fix a minimum interest rate for one or more future money market investments (deposits), thus protecting him against falling interest rates

What is Interest Rate Floor?

It is an option contract between two parties regarding money market interest rate. This contract concerns an agreed principal and an agreed series of interest periods. This will be against a payment of a premium that will be paid in advance. The buyer of the Floor option agreement will guarantee a minimum of an agreed interest rate from the seller.

At the start of each agreed interest period, The agreed Floor rate is compared with the money market interest rate (MMR) applicable at that (e.g. LIBOR ). If the MMR is lower than Floor agreed rate. Terrastone Financial Services will pay the difference to the buyer (Client) at the end of the interest period. If MMR is higher than Floor agreed rate, no settlement takes place. The investor or the depositor therefore will benefit entirely from a favorable move in interest rate.

Basic Parameters

  • It can be arranged for a series of interest rates receivable in the future (e.g. from deposits).
  • It’s exclusively relates to an interest rate difference to be settled and is separate from underlying principal transaction.
  • The market value of the bought interest Rate Floor can either rise or fall, but will never become negative.(Financial Institution will not require any security for a purchased interest Rate Floor).

An Example of Interest Rate Floor
For example, Exhibit 1 illustrates a 3-year, USD 200 MM 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.

Libor Rate Margin Without Floor Settlement under Floor Result With Floor Result W/ fixed rate
3.5% 0.25% 3.25% 1.25% 3.80% 4.75%
4.5% 0.25% 3.25% 0.25% 3.80% 4.75%
5.5% 0.25% 5.25% N.a 4.55% 4.75%
6.5% 0.25% 6.25% N.a 5.55% 4.75%
7.5% 0.25% 7.25% N.a 6.55% 4.75%
8% 0.25% 7.25% N.a 7.05% 4.65%

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.

Floor Risks and Benefits

The investor buys the Floor to protect itself against an unfavorable rate movements, premium is paid in advance. If rates movements fail to materialize, investor can see that paid premium as a loss. However he can take full advantage of it in case of favorable interest rate movement.

Also, it allows the investor to secure a minimum to interest rate income of future money market deposits. A Floor Option agreement is a customized product. Effective Date, Expiry Date, the agreed rate and frequency of interest rate payment/ receipts can be tailored subject to investor requirements vision. In addition, it can be arranged for fixed or variable principal sum (to be arranged in advance).

The cost of Buying a Floor are limited, so no further costs or commissions are involved. Also a Floor agreement is separate from client underlying transaction or deposit.

It can be sold in the interim for the then applicable premium. This can be reduced or even neutralized (Zero Cost) by making use of a combination strategy of interest rate Cap and Floor.

The above information is not a recommendation or investment advice and appears for information purposes only. While information given believed to be reliable, Terrastone Financial Services guarantee its accuracy or completeness, and accept no responsibility whatsoever (including any loss suffered by any company or individuals) resulting from trading on its basis. No rights can be gained from this publication. There are risks involved in this product.

NOTE:
The information given is not a recommendation or investment advice and appears for information purposes only. While information given believed to be reliable, Terrastone Financial Services guarantee its accuracy or completeness, and accept no responsibility whatsoever (including any loss suffered by any company or individuals) resulting from trading on its basis. No rights can be gained from this publication. There are risks involved in this product.

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