I am having a difficult time understanding interest rate floors and the relation to short interest rate puts. How can a short interest rate put provide downside protection against falling rates? Perhaps I’m thinking too much in terms of equities – if you are short a put on a stock you gain when the stock goes up, not when it goes down. If someone can help me understand how short interest rate puts work I would appreciate it - how does this provide an interest rate floor. I’ve searched other postings and still don’t understand. Thanks.
Because there is ambiguity in “interest rate puts”. When I think “interest rate puts” I think Eurodollar futures puts - the most often employed interest rate puts in the world. If you have sold a 96 ED put, you gain when the ED contract goes up. Since a 96 ED contract corresponds to a LIBOR rate of 4% and a 97 ED contract corresponds to a LIBOR rate of 3%, that means I am betting that interest rates will fall.
Okay, I think I understand now. I was thinking that a short interest rate put would profit from rising rates but what I understand you saying is that it’s profiting from a rise in the contract price which is inversely related to the interest rate…correct?
That’s right. Don’t think of them as puts on the rates, but as puts on the contract price.