Inverse Floater is a bond or other type of debt instrument whose coupon rate is inversely related to the Reference Rate. Investors using Inverse Floaters assume the risk of potentially losing their investment due to changes in interest rates.
To calculate the coupon rate for the Inverse Floater, you will need to subtract the Reference Rate from the fixed-rate payable on security. Thus, when the Reference Rate increases, the coupon rate decreases, since the rate is deducted from the amount of the coupon payment. A higher interest rate means that a larger amount is deducted and the bondholder will be paid less. Similarly, when interest rates drop, the coupon rate increases because a smaller amount is deducted from the coupon rate.
The general formula for the coupon rate can be expressed as:
Coupon rate = Fixed rate – (Leverage x Reference Rate)
Coupon leverage is the ratio by which the coupon rate will change when the base rate changes by 100 basis points (bps).
Example of Inverse Floater
A typical Inverse Floater may have a maturity of three years, pay interest quarterly, and include a floating rate of 7% minus the double 3 Month LIBOR Rate. In this case, if LIBOR increases, the rate of bond payments will reduce. For such securities, the lower limit of the coupon rate is usually set to zero.
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