An interest rate floor acts like insurance against low interest rates.
The floor buyer pays a premium for the floor in exchange for extra income when interest rates rise fall below a chosen minimum, the floor rate. The further that rates fall below the floor rate, the greater the extra income from the floor.
The risk of a floor is that the buyer pays a premium for the floor but receives nothing in return, for example if interest rates remain above the floor rate for the duration of the instrument.
Favourable floors may be purchased to offset the risks of the adverse floors contained in fixed rate loans.
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