As short-term interest rates fall, both the market price and the yield of the inverse floater increase.
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.
[3] 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.
Caps and floors are often placed within inverse floaters to avoid unattractive features to investors (such as a negative coupon).
Inverse floaters are issued in the collateralized mortgage obligation (CMO), municipal, and corporate markets.
[3] The CMO inverse floater is considered a more complicated instrument to hedge and analyze, and is usually sold to sophisticated investors.
As such, the following relationship must hold: Based on this formula and value of the collateral, it can not be assumed that a decrease in the reference rate will automatically translate into a gain for the inverse floater.