Interest Rate Floor And Collar

This is a short article to explain what an interest rate collar is and how interest rate options may be used to create one.

Interest rate floor and collar.

In an interest rate collar the investor seeks to limit exposure to changing interest rates and at the same time lower its net premium obligations. A borrower would buy a cap and sell a floor thereby offsetting the cost of buying a cap against the premium received by selling a floor. Caps floors and collars 13 interest rate collars a collar is a long position in a cap and a short position in a floor. The cap rate is set above the floor rate.

An interest rate collar or floor ceiling is an agreement where the seller or provider of the collar agrees to limit the borrower s floating interest rate exposure to a specified ceiling rate and floor rate. So for example if we buy a put option at a strike price of 92 00 then we will be fixing a maximum interest rate of 8. Whenever the interest rate is above 10 the investor will receive a payment from. An interest rate collar is the simultaneous purchase of an interest rate cap and sale of an interest rate floor on the same index for the same maturity and notional principal amount.

Let s say an investor enters a collar by purchasing a ceiling with a strike rate of 10 and sells a floor at 8. For example as a borrower with current market rates at 6 you would pay more for an interest rate collar with a 4 floor and a 7 cap than a collar with a 5 floor and a 8 5 cap. A collar involves using interest rate options to confine the interest paid or earned within a pre determined range. An interest rate floor is an agreed upon rate in the lower range of rates associated with a floating rate loan product.

A depositor would buy a floor and sell a cap. The premium for an interest rate collar depends on the rate parameters you want to achieve when compared to current market interest rates. The objective of the buyer of a collar is to protect against rising interest rates while agreeing to give up some of the. Hence the investor goes long on the cap floor that will save it money for a strike of x s1 but at the same time shorts a floor cap for a strike of x s2 so that the premium of one at.