Inverse floaters

An inverse floating-rate note pays coupons that increase if the reference rate decreases. Therefore, this bond gives a benefit at investors with a negative yield curve. The coupon structure of inverse floaters usually is determined as a fixed interest rate less a variable interest rate linked to a reference index. Moreover, they can include floor provisimis. 

There are several features about floaters that deserve mention. First, a floater may have a restriction on the maximum (minimum) coupon rate that be paid at any reset date called a cap (floor). Second, while a floater s coupon rate normally moves in the same direction as the reference rate moves, there are floaters whose coupon rate moves in the opposite direction from the reference rate. These securities are called inverse floaters. As an example, consider an inverse floater issued by the Republic of Austria. This issue matures in April 2005 and delivers semiannual coupon payments according to the following formula ... 

An inverse floating-rate note, or inverse floater, pays a coupon that increases as general market rates decline. It offers enhanced returns to investors who, in contrast to the market consensus, believe the outlook for bonds is generally positive. These notes are suitable when inflation is low and the yield curve positive, both conditions that would, in a conventional analysis, suggest rising interest rates in the medium term. Inverse floaters may also be appropriate when the yield curve is negative, i.e., inverted, should the investor agree with the market consensus, which would be for lower rates in the medium term. 

The coupon on an inverse floater may be determined in a number of ways. The most common is to subtract from a specified fixed interest rate a variable that is linked to a reference index. Coupons have a floor, which, if unspecified, is 0 percent. 

Issuers of inverse floaters are usually corporations. The notes may also, however, be issued to meet specific client requirements, by specialized... 

The inverse floater in figure 13-1 pays a slightly above-market initial coupon given a positive yield curve. Investors benefit because they get a coupon whose sensitivity is equal to two times the changes in LIBOR. 

Figure 13.1 specifies that the inverse floater has a minimum coupon on 0 percent. The floor is passed on from the note issuer to the swap bank via the swap. This, in eflfect, caps the note holders LIBOR exposure at 7.875 percent (15.75 divided by two). The bank s swap leaves it exposed to a rise in LIBOR above this level. To be fully hedged, the bank must buy an interest rate cap on LIBOR with a strike rate of 7.875 percent. The cap costs 15 basis points, which explains the spread over the coupon rate in the swap structure. 

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