A floor in derivatives is a contract feature that sets a minimum level for a payment or rate in a floating-rate arrangement. It is most commonly used with a cap in a cap-and-floor structure to limit both downside and upside of cash flows.
In a floating-rate setting, a floor guarantees that payments on a given leg do not fall below a specified rate. If the observed reference rate is below the floor, the floor pays the difference between the floor and the rate; if the rate is above the floor, no payment is triggered. Economically, a floor is often viewed as a portfolio of put options on the reference rate, with payoff (K - R)^+ where K is the floor rate and R is the realized rate. This structure provides protection against very low rates while leaving upside when rates rise.
Floors are used to stabilize income from floating-rate instruments or to hedge against falling reference rates in a portfolio. They can be embedded in floating-rate notes or interest-rate swaps, or traded as standalone floor contracts in over-the-counter markets. The cost of a floor generally reflects the probability-weighted likelihood of rates hitting the floor and the magnitude of potential payoffs.
Example: A $1 million notional floating-rate note carries a floor of 0.50%. If the reference rate for a period is 0.30%, the floor payoff is 0.20% of notional, providing a minimum level of income for that period.
Cap · Cap/Floor · Interest Rate Swap · Floating-Rate Note · Put Option on Interest Rates · Reference Rate