Instrument Features, Cash Flows, and Types: practice question
Peltarine Energy has issued an inverse floating-rate note whose coupon rate each period equals 6.80% minus the six-month reference rate, subject to a minimum coupon rate of 1.50%. For the period about to begin, the reference rate has just been set at 6.10%. The coupon rate that will apply for that period is closest to:
- 0.70%
- 1.50%
- 5.30%
Show answer and explanation
Correct answer: B
Working: Formula gives 6.80% - 6.10% = 0.70%; because 0.70% is below the 1.50% minimum, the floor binds and the coupon rate is 1.50%.
Explanation: The formula output of 6.80% - 6.10% = 0.70% falls below the note's 1.50% minimum coupon, so the floor binds and investors receive 1.50%. The 0.70% figure applies the formula mechanically and overlooks the floor, whose purpose is to keep the coupon from approaching zero as the reference rate rises. The 5.30% figure floors the reference rate instead of the coupon (6.80% - 1.50%), misreading the minimum as a limit on the index rather than on the coupon paid.
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