Normally, floater coupon rate moves in the same direction as the reference rate. That is, with an increase in the reference rate, the floater coupon rate also increases and vice-versa. However, in inverse floaters or reverse floaters, the coupon rate moves in the opposite direction of the reference rate. Formula to calculate coupon rate for an inverse floater is
Coupon rate = K - (L x Reference rate)
Where, K and L are constant values set forth in the prospectus of the issue.
Let us say that K is 25% and L is 3 and the reference rate is 3 months LIBOR, which is at 2.5%.
The coupon rate of the reverse floater is determined as follows:
Coupon rate = 25% - (3 x 2.5%) = 17.50%.
If we assume that the 3 months LIBOR is 3.5%, then the coupon rate for next interest payment period is
= 25% - 3 x 3.5% = 14.50%.
If the 3 months LIBOR is 1.5%, then the coupon rate for next interest payment period is:
= 25% - 3 x 1.5% = 20.50%.
From the above illustration, we clearly see how the coupon rates of an inverse floater move with the increase and decrease of reference rates.