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In Finance, what is a Drop Lock?

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  • Written By: Mary McMahon
  • Edited By: C. Wilborn
  • Last Modified Date: 26 November 2016
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A drop lock is a term attached to a security with a floating interest rate that locks the interest rate if it drops to a specific level. Drop locks are not available with all securities that have a floating rate, and they tend to be features on things like preferred stock and other specialized security products. People preparing to buy securities can find out whether or not they have a drop lock and when it will be triggered by asking the broker or dealer for more information or consulting a personal finance advisor.

Drop locks can be used with bonds, currency, and a variety of other security products. The time at which point the interest rate will become fixed instead of floating is known as the trigger. Triggers can be set to various amounts, depending on the economic conditions and the security itself. One advantage of the drop lock is that it protects people when interest rates are falling as their securities with floating rates will eventually stabilize. In a period of economic turmoil, rates can drop very low, devaluing securities quite rapidly in some circumstances.

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In some cases, investors arrange a secondary contract so that in the event the interest rates on their securities start to fall, they are automatically sold off. This may be designed to happen at the trigger point or at a slightly higher rate. People utilize such contracts to protect their investments and the structure of their portfolios. It is possible to take a loss when selling securities during periods of falling interest rates, however, as demand for those securities, even with a drop lock, will be low since no one else wants to take a hit on the interest rate either.

The advantage to a floating rate note for investors is that there is a possibility that the interest rate will rise. If the economy or the issuer of the securities is doing well, the interest rate will rise correspondingly. Poor performance, on the other hand, drags the interest rate down. It is possible for interest rates to hover near zero during periods of very poor performance and this can make a floating rate note a very risky investment. The drop lock reduces the risk.

When people make arrangements to buy a security, they will be provided with information about the security. It also behooves them to do some research about the issuer. Many financial publications rate individual securities as well as issuers, and this information can be very valuable when conducting research on what to buy and when.

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