Benefit of selling a Floor? buying, benefits, understand, interest, additional

rosewhite

How does selling a floor benefit to a floating rate borrower by offsetting some of the costs of buying an Interest rate cap option?

If the interest rates goes down than the floor, the short on floor has to make additional payments which is a disadvantage of selling a floor.

I failed to understand the benefits. Can someone explain?

dece2011

CFA_2012, you are exactly right that if interest falls below the floor then the floating rate borrower is actually worse off because he/she needs to make up for the additional payments.

The sole advantage of selling a floor in this case is to use the proceeds to offset the cost of buying a call option even though selling a floor is disadvantageous for the borrower if interest rate falls.

In a nutshell, you capped the interest rate you have to pay at the upper end (via the call option/ceiling) and at the same time capped the interest rate you have to pay at the lower end (through the put option/floor), hence the interest rate "collar".