What occurs when a specified interest rate index falls below a certain rate in an interest rate floor?

When a specified interest rate index falls below a certain predetermined rate in an interest rate floor, the purchaser of the floor receives payments. An interest rate floor is a financial derivative that provides the holder with payments when the underlying interest rate falls below a specified level, known as the strike rate. This ensures that the holder will receive a minimum return on their investment or borrowing costs, thus offering a form of protection against declining interest rates.

In practical terms, if the market interest rate drops below the level set by the floor, the floor holder will receive payments from the counterparty (often a bank or financial institution) that reflect the difference between the market rate and the floor rate. This arrangement benefits the purchaser by providing additional cash flow during periods of falling interest rates, reinforcing the function of interest rate floors as a risk management tool for managing interest rate exposure.