An inverse floater swap is a swap where:
The structured coupon is based on a formula which is calculated as follows:
Fixed rate – floating rate x gearing factor.
In other words, the coupon is calculated as the difference between a fixed rate and a specified interest rate index.
As a result the coupon is inversely related to the interest rate. That is, it rises as the interest rate falls and falls as the interest rate rises. The receiver of the inverse floater coupon is therefore looking for the chosen floating rate to drop over the swap term.
The other leg is based on a floating rate or a fixed rate.
The risk to the receiver of the inverse formula leg is two-fold:
The maximum payout is necessarily capped by the fixed rate set for that leg.
In addition, setting a maximum coupon for this leg adds an additional cap to the potential payout.
If the interest rate index specified for that leg rises above the fixed rate, the receiver of inverse formula leg will have to make a payout on this leg as well.
However, the risk associated with this last outcome will usually be negated by setting the minimum coupon for this leg to zero. This will prevent the coupon payment from having a negative value (if the difference between the fixed rate and the interest rate falls below zero), and protect the receiver from the situation of having to pay on both legs of the swap.
Example of an Inverse Floater Swap
You have entered into a 2Y EUR inverse floater swap where you receive the inverse floater leg. This leg is set to 6.5% - 6m Euribor, with a minimum coupon payout of 0 and a maximum coupon payout of 4.
If on the first fixing date the 6m Euribor is:
4.4% you receive 2.1%.
1.2% you receive 4% because you capped the maximum payout at 4%.
6.8% you receive nothing. However, you do not have to pay anything to the payer of this leg because setting the minimum coupon to 0 protected you from a negative payout.
Advantages of an Inverse Floater Swap
An inverse floater swap offers a high potential coupon in exchange in return for a small risk, i.e., that the interest rate index will rise above the fixed rate during the term of the swap. Furthermore, this risk can be negated by defining a minimum coupon payout for the inverse formula leg.
These trades are very popular (in bond format) when investors feel that short term rates are likely to fall. The greater the fall in the chosen index, the larger the resultant coupon.
The inverse floater is mostly regarded as a speculative tool.
Pricing an Inverse Floater Swap in SDX Interest Rates
To price an inverse floater swap in SDX Interest Rates, you select the Callable Inverse Floater and then select the non-callable style.
When pricing the inverse formula leg you need to be aware of the following:
When you calculate the instrument the system automatically calculates the fixed rate for you. Alternatively you can define it manually.
You can define a Gearing value.
By default the minimum coupon payout is set to zero (which means the payout cannot be a negative amount) and the maximum coupon is not specified. Changing these fields allows for a more precise payoff and consequently a different risk/reward profile.