A Floor Rate Agreement acts like insurance that protects lenders and investors against interest rate declines on variable-rate assets. When the market interest rate, often based on a benchmark like SOFR (Secured Overnight Financing Rate), falls below a pre-agreed floor rate, the seller of the agreement pays the difference to the buyer. This guarantees the buyer a minimum return, helping stabilize their income.
How Does a Floor Rate Agreement Work?
This agreement is a financial derivative, meaning its value derives from an underlying interest rate rather than an exchanged principal. Key components include:
- Notional Principal: The hypothetical amount the contract references for calculations but is not actually exchanged.
- Reference Rate: The floating benchmark interest rate the contract tracks, typically a rate like SOFR.
- Strike Rate (Floor Rate): The minimum interest rate agreed upon. Payments occur only if the reference rate drops below this rate.
- Premium: The fee the buyer pays upfront to gain this protection.
- Term: The timeframe over which the agreement is active.
If on any payment date the benchmark rate is below the floor rate, the seller pays the buyer an amount calculated as (Strike Rate – Reference Rate) × Notional Principal × (Days in Period ÷ 360). This payment compensates for reduced interest income on the underlying loan or asset.
Practical Example
Consider a community bank that issues a $1 million loan with an interest rate of SOFR + 3%. The bank fears SOFR could fall below 2%. To manage this risk, it purchases a Floor Rate Agreement with a 2% floor on SOFR for three years. If SOFR falls to 1.5%, the agreement seller pays the bank the 0.5% difference on the $1 million principal, offsetting losses from lower interest payments.
Floor Rate Agreement vs. Interest Rate Cap
To avoid confusion, a Floor Rate Agreement should not be confused with an Interest Rate Cap. While the floor protects lenders from falling rates, a cap protects borrowers from rising rates. These two can be combined into an interest rate collar for managing interest rate risk.
- For more on how an interest rate cap works, see Interest Rate Cap.
- Learn about combined protections in an Interest Rate Collar.
Important Distinction
A Floor Rate Agreement is distinct from a floored loan. A floored loan embeds a minimum interest rate within the loan terms itself. In contrast, a Floor Rate Agreement is a separate contract purchased independently as a hedging tool.
Who Uses Floor Rate Agreements?
Typically, these instruments are utilized by banks, credit unions, and institutional investors managing substantial portfolios of variable-rate assets. They are not common for individual borrowers or small businesses.
Additional Resources
For more detailed information, consult Investopedia’s Interest Rate Floor and the Corporate Finance Institute’s guide on Interest Rate Floors. Also, explore related financial derivatives and interest rate risk management strategies available on FinHelp.io such as Adjustable-Rate Mortgage (ARM) and Fixed Interest Rate.
Floor Rate Agreements are valuable tools that help stabilize returns in volatile interest rate environments by setting a guaranteed minimum income for lenders and investors.