I’m a little confused by the wording in Scheweser’s notes.
April 15, a bank makes a one-year floating rate loan for $10M. Payments are due: July 15, Oct 15, Jan 15, Apr 15.
Bank then buys a 9-month, quarterly pay floor.
The part I’m confused is in this sentence:
"Because the first loan interest payment is known at initiation of the analysis, the first floorlet expires July 15 with payoff (if in the money) on October 15."
^I understand how the first floorlet does not cover the first period because the interest rate is known at inception, but what does “with payoff (if in the money) on October 15” mean? Shouldn’t the first floorlet not have any payoff at all since it doesn’t cover the first period because the first interest rate is known?
This payoff is for the second floorlet correct? The first flooret expired on July 15 and doesn’t serve any purpose even if the underlying rate is less than the strike on April 15.
This is for the first floorlet. It expires on July 15 and pays on October 15.
By the way, there’s no reason that you couldn’t buy a floor where the first floorlet expires on April 15 and pays on July 15. If there’s a positive payoff the present value of that payoff would be added to the cost of the floor.
You said that it expires on July 15 and pays on October 15. That means that on July 15 you compare the market rate to the strike rate and, if it’s in the money, it makes a payment on October 15.