A vanilla floor, more commonly known simply as a floor, protects its buyer from a drop in the interest rate index below the level (or strike) specified in the contract.
The floor itself consists of a series of floorlets. Each floorlet successively ensures its buyer protection against a fall in a specified interest rate below the strike for a single payment period of the floating rate liability.
That is, if on the floorlet’s fixing date (usually set at the start of the payment period) the interest rate index is below the strike, the floor seller must pay the floor buyer a payoff as follows (on the payment date at the end of the floorlet’s period):
[MAX(strike - interest rate index,0) * notional * relevant daycount fraction]
Usually the reference rate is set in advance, i.e., it is set at the start of each payment period and paid at the end of that payment period. However, it can also be set in arrears.
In return for this protection the buyer of the floor pays a premium to the seller. The premium, which is expressed as a percentage of the notional, is usually paid upfront. However, it can also be paid in installments over the life of the floor.
Advantages of a Floor Option
Buying a floor lets you hedge yourself against falling interest rates for a specified period, while giving you the flexibility to benefit from any rise in rates.
Pricing a Floor in SDX Interest Rates
When pricing a floor in SDX Interest Rates there are a number of things to be aware of:
The premium, which is expressed as a percentage of the notional, is usually paid upfront. However, it can also be paid in installments over the life of the floor.
The upfront payment to be made for a floor is shown in the Market Price result. The Amortize premium result shows the annual periodic payment that would be paid if the floor was bought in installments.
By default the Amortize premium result is not displayed. You can choose to display it in the Settings window. For more information see Displaying the Cap/Floor Premium as an Amortized Value .
By default, the system sets each payment on the relevant floorlet’s end date. You can change these dates manually. In addition, you can instruct the system to set the payments on the floorlets’ start dates instead.
For more information on this functionality see Configuring Payments to Coupon and Caplet Start Dates.
You can also enter your own market volatility and then re-calculate the Greeks and various values. See Market Vol.