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Interest Rate Swap and 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 receiving a floating rate that matches the loan (i.e. three month LIBOR) from the Bank. By purchasing a Floor, the Borrower acquires the flexibility to benefit if the floating rate is below the Floor strike rate. The premium for the Floor is embedded into the Swap rate so there is no upfront cash premium.

Objectives

The purpose of an Interest Rate Swap and Floor is to restore some of the opportunity for the Borrower to benefit from a low interest rate environment, and to limit the potential penalty cost that could arise on early termination when interest rates are lower than at inception.

How does it work?

The floating rate will be 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, against this payment, the difference between the Floor strike rate and the floating rate.

Advantages
  • It provides the Borrower with the comfort of a known maximum rate of interest
  • It allows the Borrower limited opportunity to benefit from low short-term interest rates should they fall below the strike rate of the Floor
  • It enables the Borrower to restrict the potential penalty costs arising on early termination, being the difference between the Swap rate and the Floor strike rate
  • 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 example:

 

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