Inverse floater

An ordinary floating-rate bond resets its coupon in line with a benchmark: when the benchmark rises, the coupon rises with it. The bond exists to track the market, not fight it.

An inverse floater does the opposite. The workbook's definition (section 3.3.2): "bonds whose coupons move inversely to the benchmark. These are known as 'inverse floaters'." When market rates rise, the coupon on an inverse floater falls; when market rates fall, the coupon rises.

The workbook notes this instrument is a feature of developed markets rather than something it illustrates with an Indian issue.

To see why an inverse floater exists, start from the ordinary floating-rate bond the same section describes. Its coupon is "reset periodically with reference to a defined benchmark" — the inflation index, inter-bank rates, call rates or a similar reference — typically every 6 months, so that the bond "pay[s] interest that reflect[s] current market rates." That resetting is what gives a floater its lower interest rate risk relative to a fixed-rate bond of the same maturity: the coupon chases the market instead of staying stuck at issue-date levels.

An inverse floater takes that same periodic-reset mechanism and flips the sign. A typical structure (not itself numbered in the workbook, but the standard construction of such an instrument) fixes a ceiling rate and subtracts the benchmark from it:

Inverse floater coupon = Fixed reference rate − Benchmark rate

Because the coupon is defined as a fixed rate minus a floating benchmark, a rise in the benchmark subtracts more and pushes the coupon down; a fall in the benchmark subtracts less and pushes the coupon up. The same section also introduces Cap and Floor — the maximum and minimum limits some floating-rate bonds place on their coupon — and an inverse floater typically needs a floor at zero, since the subtraction could otherwise imply a negative coupon if the benchmark rises high enough.

Illustrative structure — the workbook names inverse floaters but does not itself number a formula.

Coupon = Fixed reference rate − Benchmark rate  (subject to a floor, typically 0%)

Illustrative figures, built on the workbook's floating-rate bond mechanism (section 3.3.2).

An inverse floater is structured with a fixed reference rate of 12% and a floor of 0%, resetting every six months against the prevailing MIBOR (Mumbai Interbank Offer Rate) — the same reset frequency the workbook gives for ordinary floating-rate bonds.

Coupon = 12% − MIBOR

An investor, Mr Deshmukh, holds Rs 10,00,000 face value of this bond. When MIBOR rises from 6.5% to 8.0% between Reset 1 and Reset 2, his half-yearly coupon falls from Rs 27,500 to Rs 20,000 — the opposite of what happens to a holder of an ordinary floating-rate bond, whose coupon would have risen on the same move. Mr Deshmukh chose the inverse floater because he expected rates to fall, which is exactly what happens at Reset 3, lifting his coupon to Rs 35,000.

Chapter 3 (Terminology in Equity and Debt Markets), section 3.3.2 (Floating-Rate Bonds), names inverse floaters directly after explaining Cap and Floor on ordinary floaters. The question the workbook sets up is conceptual rather than numerical: does the candidate know that an inverse floater's coupon moves opposite to its benchmark, in contrast to an ordinary floater, which moves with it.

• The coupon moves opposite to the benchmark — up when the benchmark falls, down when it rises. This is the reverse of an ordinary floating-rate bond and is the one fact the workbook states outright.
• Do not confuse Cap/Floor with inverse. Cap and Floor set upper and lower limits on a coupon that still moves in the same direction as the benchmark; an inverse floater flips the direction itself.
• The workbook places inverse floaters in developed markets, not as a Indian-market illustration — do not invent an Indian issuer for this instrument.
• The formula shown here (fixed rate − benchmark) is illustrative, built on the general floating-rate mechanism the workbook does describe (periodic reset against a benchmark, typically every 6 months) — the workbook itself gives no worked inverse-floater coupon calculation.
• An inverse floater still carries interest rate risk, just directionally reversed from a fixed-rate bond — it is not risk-free simply because it moves opposite to the market.