An Interest Rate Floor is a type of financial derivative contract that effectively sets a minimum interest rate for an investment or loan. Think of it as an insurance policy against falling interest rates. The buyer of the floor pays an upfront fee, known as a premium, to the seller. In return, if a specified benchmark interest rate (like SOFR) drops below a pre-agreed level (the “floor” or strike rate), the seller must pay the buyer the difference. This protects lenders or investors who earn income from floating-rate assets. If your income is tied to a rate that could sink, a floor ensures it won't drop below a certain level, providing you with a predictable minimum return. For the seller, typically a large financial institution, they collect the premium and bet that rates will stay above the floor, allowing them to pocket the fee as pure profit.
At its core, an interest rate floor is a series of individual derivative contracts called “floorlets,” each corresponding to a specific payment period over the life of the agreement. When a payment date arrives, the reference interest rate is compared to the floor's strike rate. Imagine you've invested in a bond that pays you an interest rate that changes every three months. You're worried that the central bank might cut rates, which would shrink your income. To protect yourself, you buy an interest rate floor. Let's break down the key parts:
Now, let's say at the end of the first three-month period, the SOFR has fallen to 1.5%. Because the market rate is below your 2% strike rate, the floor is “in the money.” The seller must pay you the difference. The payout is calculated based on the notional principal (0.5% x $1 million for the period). If