- Inverse floating rate note
An

**inverse floating rate note**, or simply an**inverse floater**, is a type of bond or other type of debt instrument used in finance whose coupon rate has an inverse relationship to short-term interest rates (or itsreference rate ). With an inverse floater, as interest rates rise the coupon rate falls. [*[*] The basic structure is the same as an ordinary*http://www.investopedia.com/terms/i/inversefloater.asp Inverse Floater*] ,Investopedia.com , Retrieved onMarch 20 ,2008 floating rate note except for the direction in which the coupon rate is adjusted. These two structures are often used in concert.As short-term interest rates fall, both the

market price and the yield of the inverse floater increase. This link often magnifies the fluctuation in the bond's price. However, in the opposite situation, when short-term interest rates rise, the value of the bond can drop significantly, and holders of this type of instrument may end up with a security that pays little interest and for which the market will pay very little. Thus,interest rate risk is magnified and contains a high degree of volatility. [*[*]*http://72.14.205.104/search?q=cache:bdsMsi3X3p8J:insr.wharton.upenn.edu/babbel/Inverse.doc Inverse Floaters and the Income Stability of a Debt Securities Investment Portfolio*] , Wharton - Insurance Risk Management, Retrieved onMarch 20 ,2008 **Creation**An inverse floating rate note can be created two ways. The first is by placing an existing or newly underwritten fixed-rate security into a trust and issuing both a floating rate note and an inverse floating rate note. The second method is for an investment banking firm to underwrite a fixed-rate security and then enter into an

interest rate swap that has a maturity less than the bond's term. The investor would then own an inverse floater until the swap agreement expires. When creating an inverse floater through the swap market the need to sell in inverse floaters through aDutch auction is eliminated. In the first scenario the original security placed in trust is referred to as the collateral, from this collateral both the floater and inverse floater are created. The dealer will split up the underlying fixed-rate asset at a specified ratio (e.g. 20/80) and assign each portion to inverse and floater.The reference rate and the frequency at which the rate is reset are contractually set. The rate used is often some form of

LIBOR , but it can take different forms, such as tying it to theconsumer price index , a housing price index, or an unemployment rate. The rate can be allowed to reset on an immediate, daily, or some type of monthly or yearly schedule. The rate can be computed by taking its set stated rate and subtracting the reference rate at the reset date. Caps and floors are often placed within inverse floaters to avoid unattractive features to investors (such as a negative coupon). Typically, the floor is set at zero and a cap may be set (e.g. 10%). If a floater is involved a cap is put on the floater to match up with the inverse's floor, and vise versa. This is done since both are derived from the same fixed rate asset.**Issuers**Inverse floaters are issued in the

collateralized mortgage obligation (CMO), municipal, and corporate markets.**CMO**The CMO market is the largest issuer of inverse floaters.cite book | last = Fabozzi | first = Frank J. | coauthors = Steven V. Mann | title = Floating-Rate Securities | publisher =

John Wiley and Sons | date = 2002 | pages = 202-217 | isbn = 1883249651] The CMO inverse floater is considered a more complicated instrument to hedge and analyze, and is usually sold to sophisticated investors. The collateral in this market refers to mortgage-related products which create the CMO, this is known as "CMO collateral." The fixed-rate asset, ortranche , is used to create the floater and inverse floater is known as the "tranche collateral."**Municipal**In the municipal market, the investor of a inverse floater can purchase the corresponding floater at an

auction and combine the two positions to essentially own the underlying asset. The investor can elect to split the issue again and retain the inverse floater portion. This option can be valuable to investors, but generally carries less yield than a comparable fixed-rate bond that does not carry this option. The ratio of floaters to inverse floaters is usually 50/50.**Corporate**Almost all corporate inverse floaters are issued as structured notes, which mean that they are part of an underlying swap transaction.

**Leverage and valuation**Additional valuation of an inverse floater can be determined by looking at the security's

coupon leverage . To illustrate, suppose the creator of the floater and inverse floater divides the underlying collateral up into 100 bonds, 20 inverse an 80 floater bonds.The leverage in this structure is 4:1 of floater to inverse bonds. As such the following relationship must hold::$100(mbox\{collateral\; price\})\; =\; 20(mbox\{inverse\; price\})\; +\; 80(mbox\{floater\; price\})$

Based on this formula and value of the collateral, it can not be assumed that a decrease in the

reference rate will automatically translate into a gain for the inverse floater. Such scenarios can be attributed to changes in the overall market and theyield curve that negatively impact the collateral's value.**ee also***

Auction rate security

*Collateralized debt obligation

*Float (finance)

*Inflation-indexed bond **References**

*Wikimedia Foundation.
2010.*

### Look at other dictionaries:

**Inverse floating rate note**— A variable rate security whose coupon rate increases as a benchmark interest rate declines. The New York Times Financial Glossary … Financial and business terms**inverse floating-rate note**— A variable rate security whose coupon rate increases as a benchmark interest rate declines. Bloomberg Financial Dictionary … Financial and business terms**Floating rate note**— Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a spread. The spread is a rate that remains constant. Almost all FRNs have quarterly coupons, i.e.… … Wikipedia**Floating-Rate Note - FRN**— A note with a variable interest rate. The adjustments to the interest rate are usually made every six months and are tied to a certain money market index. Also known as a floater . These protect investors against a rise in interest rates (which… … Investment dictionary**Inverse Floater**— A bond or other type of debt whose coupon rate has an inverse relationship to a benchmark rate. An inverse floater adjusts its coupon payment as the interest rate changes. When the interest rate goes up the coupon payment rate will go down… … Investment dictionary**Credit-linked note**— A credit linked note (CLN) is a form of funded credit derivative. It is structured as a security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit investors. The issuer is not obligated to repay … Wikipedia**Interest rate derivative**— An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a (usually notional) amount of money at a given interest rate.The interest rate derivatives market is the largest derivatives market in the… … Wikipedia**Collateralized mortgage obligation**— Financial markets Public market Exchange Securities Bond market Fixed income Corporate bond Government bond Municipal bond … Wikipedia**Credit derivative**— In finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the… … Wikipedia**Mortgage-backed security**— Securities Securities Bond Stock Investment fund Derivative Structured finance Agency security … Wikipedia