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 a Dutch 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 the consumer 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 vice versa. This is done since both are derived from the same fixed-rate asset.
Read more about this topic: Inverse Floating Rate Note
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