Interest Rate Collar
What Is an Interest Rate Collar?
An interest rate collar is a somewhat low-cost interest rate risk management strategy that utilizes derivatives to hedge an investor's exposure to interest rate variances.
Understanding Interest Rate Collar
A collar is a broad group of options strategies that include holding the underlying security and buying a protective put while simultaneously selling a covered call against the holding. The premium received from [writing the call](/composing an-option) pays for the purchase of the put option. Moreover, the call caps the upside potential for appreciation of the underlying security's price yet shields the hedger from any adverse movement in the value of the security. A type of collar is the interest rate collar.
Basically, an interest rate collar includes the simultaneous purchase of an interest rate cap and sale of an interest rate floor on a similar index for a similar maturity and notional principal amount. An interest rate collar utilizes interest rate options contracts to safeguard a borrower against rising interest rates while likewise setting a floor on declining interest rates. An interest rate collar can be an effective approach to hedging interest rate risk associated with holding bonds. With an interest rate collar, the investor purchases an interest rate ceiling, which is funded by the premium received from selling an interest rate floor.
Recollect that there is an inverse relationship between bond prices and interest rates — interest rates fall as bond prices rise, and vice versa. The objective of the buyer of an interest rate collar is to safeguard against rising interest rates.
Purchasing an interest rate cap (i.e., a bond put option or rates call option) can guarantee a maximum decline in the bond's value. Albeit an interest rate floor (bond call option or rates put option) limits the expected appreciation of a bond given a diminishing in rates, it gives upfront cash and generates premium income that pays for the cost of the ceiling.
Suppose an investor enters a collar by purchasing a ceiling with a strike rate of 10% and sells a floor at 8%. Whenever the interest rate is above 10%, the investor will receive a payment from the seller of the ceiling. Assuming the interest rate dips under 8%, which is below the floor, the investor who is short the call must now make a payment to the party that purchased the floor.
Obviously, the interest rate collar strategy safeguards the investor by capping the maximum interest rate paid at the collar's ceiling however forfeits the profitability of interest rate drops.
Interest Rate Caps and Floors
A interest rate cap lays out a ceiling on interest payments. It is just a series of call options on a floating interest rate index, normally 3-or half year London Inter-bank Offered Rate (LIBOR), which concurs with the rollover dates on the borrower's floating liabilities. The strike price, or strike rate, of these options address the maximum interest rate payable by the purchaser of the cap.
A interest rate floor is the base interest rate that is made utilizing put options. It decreases the risk to the party getting the interest payments since the coupon payment every period will be something like a certain floor rate or strike rate.
Reverse Interest Rate Collar
A reverse interest rate collar safeguards a lender (e.g., a bank) against declining interest rates, which would make a variable rate lender receive less interest income on the off chance that rates decline. It includes the simultaneous purchase (or long) of an interest rate floor and sale (or short) of an interest rate cap. The premium received from the short cap halfway balances the premium paid for the long floor. The long floor receives a payment when the interest rate falls below the floor exercise rate. The short cap makes payments when the interest rate surpasses the cap exercise rate.
Features
- An interest rate collar utilizes options contracts to hedge interest rate risk to safeguard variable rate borrowers against rising rates or lenders against falling rates on account of a reverse collar.
- While the collar effectively hedges interest rate risk, it likewise limits any potential upside that would have been given by a positive movement in rates.
- A collar includes selling a covered call and simultaneously buying a protective put with a similar expiration, laying out a floor and a cap on interest rates.
