This question is from Schw: An interest rate floor on the floating-rate loan from the issuer’s perspective is: 1) long interest rate puts 2) long interest rate calls 3)short interest rate puts 4) short interest rate calls Correct answer is given as 3. How can this be? An interest rate floor is used by a lender to hedge agains the floating rate going below a certain rate. Isnt it? For example lets say the floor strike rate is 5percent and if the floating rate goes to 4 percent, the put-holder gets the 1 percent * loan amount. Isnt the put holder has the right to lend at the strike rate and if the rate goes below the strike price, he/she benefits. I am thinking the issuer here as the one who issued the floating rate loan?
The issuer here is the person who sold the floor. By “interest rate put” here they just mean something with a cash payoff if the interest rate goes below the strike at expiration.
arent interest rate floor issued by lenders who want to hedge against risk going too low…in that case wont they want to hold the put option? why will a floating rate lender want to sell the interest rate put floor…???
I look it this way Interest rate floor means an option to redeem if interest goes down than a floor interest rate. In terms of option , it is put option. As here the question is for issuer’s perspective, he is selling (issuing) bond so he is short on the same. So it is short interest rate puts
Issuer of Bond needs to make payment at floor if floor > current market IR ie incur loss. Floors dont have any impact if current IR > floor rate. Short PUT position is at loss if the IR dec as long will exercise the PUT option and earn higher IR. If IR inc, long position is of no value… So these two are equivalent…
i still dont get it: if a person is issuing a bond: then he has to pay interest rate. lets say he pays floating rate interest: LIBOR and has a short interest rate floor with a strike price of 4 percent case1: in one month time Libor: 6 percent since the person is short on the put option, the person who is long wont exercise the option because it is out of money so he essentially has to pay 6 percent on the bond no benefit to the issuer case2: in one month time libor: 2 percent since the option now in the money, the option holder will now exercise the option the bond issuer, who is also short on the put option, now has to pay for the optionholder so he losses out where is the benefit here for holding the short interest rate floor for the issuer of the bond? Am i missing something here?
Benefit is in the form of premium received at the time of issuance of put option. Idea is to sell put option and get some premium to offset cost of buying call options(cap)
I didn’t want to open a new post. So here is what I’m not that sure is correct: Looking from an issuers perspective, does that mean that he is selling the floor to somebody who wants protection from rates going down, and the only benefit he gets is the premium? Is that it? Thanx, Alex.