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Guide

Interest rate swap and floor

Summary

An interest rate swap and floor is a combination of an interest rate swap with the purchase of an interest rate floor.

What is an interest rate swap and floor?

An interest rate swap and floor is a combination of an interest rate swap with the purchase of an interest rate floor. By entering into the swap, the borrower agrees to pay a pre-agreed fixed rate of interest in return for a floating rate. By purchasing a floor, the borrower acquires the opportunity to benefit if the floating rate falls below the floor strike rate. The premium for the floor is embedded into the swap rate.

Objectives

The purpose of an interest rate swap and floor is to restore the opportunity for the borrower to benefit from a low interest rate environment. And it limits the potential penalty cost that could arise on early termination.

How does it work?

The floating rate is reset on each payment date. If on any of those dates the floating rate is higher than the embedded swap rate, the bank will pay the difference between the swap rate and the floating rate to the borrower. If the floating rate is lower than the embedded swap rate, the borrower will pay the difference to the bank. However, if the floating rate is lower than the floor strike rate, the bank will offset the difference between the floor strike rate and the floating rate.

Interest rate swap floor

Three scenarios of where the floating rate could settle and what the borrower will need to pay.

Advantages

  • It provides the borrower with the comfort of a known maximum rate of interest
  • It allows the borrower limited opportunity to benefit from lower interest rates should they fall below the floor strike rate
  • The borrower can restrict potential penalty costs arising on early termination
  • No upfront cash premium is required

Disadvantages

  • Early termination costs are rate sensitive and may be unpalatable if prevailing market interest rates at the time of termination are significantly below the fixed rate of the swap for the remaining term
Interest rate swap and floor trade example

A description of what an interest rate swap and floor trade could look like in practice.

Interest rate swap and floor example

Interest rate swap and floor graph showing the three potential outcomes over time.


Disclaimers

Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.

Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.

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