Definition of ‘Reverse floater’
Inverse floater a floating rate note in which the coupon rises when the underlying exchange rate falls. The basic rate is often the London interbank offered rate (LIBOR), the rate at which banks can borrow funds from other banks in the London interbank market, the most common benchmark for short-term interest rates.
Inverse floater, also known as reverse floating rate or inverse floater.
Breaking down the ‘Reverse float’
A floater is a fixed income by making coupon payments tied to short-term reference rate. Coupon payments are adjusted as changes in prevailing interest rates in the economy. When interest rates rise, the value of the coupons increases to reflect the higher level. You can link or reference rates include the London interbank rate of offer (LIBOR), Euro interbank offered rate (euribor), fed funds rate, US Treasury etc.
The reverse float is the float type, in which the coupon rate inversely depends on the reference interest rate. Inverse floaters are formed as a result of the separation, fixed rate bonds into two classes: (1) a float which moves directly with some rate, and (2) inverse floater that represents a residual interest with a fixed rate bond minus a floating rate. The coupon rate is calculated by subtracting the reference interest rate of the constant at each coupon date. When the reference rate goes up, the coupon rate will go down, given that the bet is deducted from the coupon payment. For example, the coupon on an inverse floater can be calculated as 10% minus 3-month LIBOR. Above the base rate will mean more will be subtracted from a constant and, thus, less will be paid to the debtholder. Similarly, as interest rates fall, the coupon rate increases, because less is subtracted from a constant.
Floating rate resets with each coupon payment and may have caps and/or floors. To prevent a situation in which the coupon rate on the inverse floater falls below zero, the limit or floor is placed on the coupons after the adjustment. As a rule, the floor is zero. In case the floor is equal to zero, and the 3-month LIBOR exceeds a constant rate, the coupon rate will be set to zero, as it cannot be negative.
Inverse floaters provide the basic and option for investors who want to benefit from falling interest rates. Like all investments that use leverage, inverse floaters to introduce a significant amount of interest rate risk. When short-term interest rates fall, market price and yield of the reverse increases the float, increasing fluctuations in the prices of bonds. On the other hand, when short-term interest rates rise, bond prices can fall significantly, and holders of this type of instrument may end security that is of little interest. Thus, interest rate risk increases and contains a high degree of volatility.