A put option on the inflation rate implied by the consumer price index (CPI) or any similar index. A stream of consecutive floorlets on the same underlying price index constitutes an inflation floor. In other words, an inflation floor is a bundle of inflation floorlets each comes into effect one the previous one expires. By nature, floorlets are not directly traded and hence their prices are not observable. Rather, floorlet prices must be implied from the observed floor prices. When an inflation floorlet is traded, the buyer and the seller agree an expiration date, a strike price (or rate) and a notional— a hypothetical amount which the seller (floorlet short) agrees to insure for the buyer (floorlet long). The buyer pays the seller an upfront premium -the option price. On expiration, the seller then pays the buyer the difference between the strike rate and the realized inflation rate multiplied by the notional amount, only if realized inflation is below the strike rate. Otherwise no money changes hands (i.e., payoff is zero).
The payoff of an inflation floorlet resembles the payoff of a vanilla option on the return of a money market account if inflation rates are replaced with interest rates. Inflation floorlets provide buyers with protection against downside risks.
Inflation floorlets are also known as inflation-indexed floorlets or inflation-linked floorlets.
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