An agreement obligating the seller to effect cash settlement to the buyer if the specified underlying interest does not exceed a predetermined level of performance is referred to as:

Question

Options

• ACap
• BFloor
• CObligatory
• DModeration

• A
  3% (1)
• B
  82% (27)
• C
  3% (1)
• D
  12% (4)

Explanation

Floor (B) is correct because a floor obligates the seller to make a cash payment to the buyer when the underlying interest (typically an interest rate) falls below a specified minimum level - the "floor" - protecting the buyer from downside performance.

Why the distractors are wrong:

• A. Cap is the opposite instrument - it pays the buyer when the underlying exceeds a maximum level, protecting against upside moves (e.g., rising interest rates).
• C. Obligatory is not a recognized derivative contract type; while floors do involve an obligation, that word alone doesn't name a specific financial instrument.
• D. Moderation is not a financial instrument at all.

Memory tip: Think of it literally - a floor is the bottom of a room; the seller pays you when the rate drops through the floor. A cap is the ceiling; the seller pays when the rate hits the ceiling.

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