What Is a Floor?
There are several meanings for a floor in finance. A floor may refer to: (1) the lowest acceptable limit by controlling parties; (2) a guaranteed lowest level for an interest rate; (3) the trading space of a physical exchange.
(1) A floor is the lowest acceptable limit as restricted by controlling parties, usually involved in the management of corporations. Floors can be established for a number of factors, including prices, wages, interest rates, underwriting standards, and bonds. Some types of floors, such as underwriting floors, act as mere guidelines while others, such as price and wage floors, are regulatory constraints that restrict the natural behavior of free markets.
(2) Interest rate floors are an agreed-upon rate in the lower range of rates associated with a floating rate loan product. Interest rate floors are utilized in derivative contracts and loan agreements. This is in contrast to an interest rate ceiling.
(3) Physical exchanges house trading floors, where floor traders and brokers engage in market transactions. Floors featured open-outcry trading located in trading pits. Physical floors have largely been replaced by computerized trading. Where trading occurs for corporations, such as banks or proprietary trading firms, is also referred to as a trading floor.
- A floor can mean multiple things in finance, including the lowest acceptable limit, the lowest guaranteed limit, or a physical space where trading occurs.
- Some floors, such as the minimum wage, are set by regulatory authorities.
- Other floors are set by a company or person to assure that a price or limit covers their costs and doesn't fall below a certain level.
Understanding a Floor
As a form of restriction, a floor provides a limit for a particular activity or transaction to which it must adhere. The floor functions as a lower limit, while a ceiling signifies the upper limit. The designated activity may be assigned anywhere from the lower to the upper limit, but is not considered acceptable if it falls below the floor level or goes above the ceiling level. This may cause deadweight loss.
Floors in Lending
Lenders use an underwriting floor to establish minimum guidelines for borrower creditworthiness and to determine the size of loan for which the borrower is qualified. These limits are imposed by the financial institution performing the service of lending and can vary from one institution to the next. For example, a person may need to have a credit score above a specified level to qualify for a loan. That specified level is the floor.
The lowest available interest rate can also be seen as a floor, as a lower rate is not available from the particular institution. Often, this minimum is designed to cover any costs associated with processing and servicing the loan. An interest rate floor is often present through the issuing of an adjustable-rate mortgage (ARM), as it prevents interest rates from adjusting below a preset level.
Floors in Pricing
A price floor is the lowest amount at which a good or service may be sold and still function within the traditional supply and demand model. Prices below the price floor do not result in an appropriate increase in demand.
Price floors may also be set through regulation and result in a minimum price requirement for the good in question. For example, the government might decide to establish a price floor for alcoholic beverages or tobacco with the goal of lowering consumption for health reasons. In the absence of a price floor, the free market equilibrium price might be lower.
Floors in Wages
Minimum wage is an example of a wage floor and functions as a minimum price per hour that a worker must be paid, as determined by federal and state governments. An unintended consequence may be an increase in unemployment, as low-skilled workers are priced out of the labor market. Failure to appropriately raise the minimum wage can lead to workers losing buying power over the long term as inflation lowers the true value of the wages being earned.
Where people trade on an exchange is called a trading floor. Globally, exchange trading floors have largely gone electronic, so there are fewer and fewer exchange trading floors left in the world.
Businesses also have trading floors, and these are spaces where the trading for a business is conducted. At proprietary trading firms, multiple traders will often be in one room making trades. Currency exchange companies may also have a trading floor, along with banks, or companies involved in the buying and selling of commodities.
Real-World Example of a Floor in Interest Rates Products
Assume a lender has secured a floating rate loan but wants to buy some protection against lost income in case interest rates decline. To get this protection, they could buy an interest rate floor contract with a floor of 3% (or whatever level they choose).
Now assume that the rate on the floating rate loan falls to 2%, which is below the interest rate floor contract level. While the company is making less on the loan, the interest rate floor contract offsets the loss by providing them with a payout.
If interest rates stay above the floor, then there is no payout and the cost of the interest rate floor contract is foregone, but the lender is receiving a rate on the loan which is above the floor level.