Ratchet floaters are a type of exotic structure that have periodic caps and a minimum coupon.They fall into the category of fixed income capital guaranteed products.
A common type of FRN (floating rate note) combined with a ratchet option pays a high floating coupon subject to a condition that the coupon cannot rise by more than a fixed amount from the previous coupon level.
An example of a ratchet floater is shown in the graphic to the right. Suppose the product is linked to the 3-month LIBOR rate and that it pays a coupon of LIBOR + 25 basis points (bps, 1 bps = 0.01%). As an additional rule, the product's coupon cannot increase by more than 25 bps per quarter. The coupon level is reset once every quarter.
The investor is effectively long an FRN and short a path-dependent or periodic cap. In the first year, rates fall and the product outperforms, but the coupon is dragged down by the steep decline of the short term rates nonetheless. Later, in a steep forward curve environment in which it is implied that rates will rise 2% or 3% over the following years, the cap that prevents any coupon increase by more than 25 bps per quarter. The note will severely underperform if rates rise as shown in the example, because the product takes several quarters to catch up with the rate increase.
- Use a ratchet floater if your rate scenario favors stable rates or a slow rate increase.
- In a steep yield curve scenario, check whether it would be worthwhile for the coupon to be linked to the 6-month LIBOR, or even to the 2 or 10 year CMS (constant maturity swap). Depending on your view on the rates, a link to a point furhter out on the forward curve may be of advantage.
Don't choose an issuer with a credit profile that you are uncomfortable with. Nowadays, coupon differences are mainly due to the issuer's funding rate.
- Ratchet floater with ladder coupon: The coupon cannot decrease below the level of the highest coupon paid. Also known as a one-way floater and sticky floater.