Interest rate collars

Interest rate collars are a tool for hedging interest rate risk.

Interest rate caps and floors

Caps

A borrower will hedge against the risk of interest rate rises by buying a put option over interest rate futures.

A cap is another name for this put option over interest rate futures.

Floors

Similarly, a depositer will hedge against the risk of interest rate falls by buying a call option over interest rate futures.

Such an option can also be called a floor.

 Interest rate collars

A company buys an option to protect against an adverse movement whilst allowing it to take advantage of a favourable movement in interest rates. The option will be more expensive than a futures hedge. The company must pay for the flexibility to take advantage of a favourable movement.

A collar is a way of achieving some flexibility at a lower cost than a straight option.

Under a collar arrangement the company limits its ability to take advantage of a favourable movement by selling an option (as well as buying one to hedge adverse movements). The premium received from the sale will help pay for the premium on the option we need to buy.

• For example, for a borrower, it buys a cap (a put option) as normal but also sells a floor (a call option) on the same futures contract, but with a different exercise price.
• The floor sets a minimum cost for the company. The counterparty is willing to pay the company for this guarantee of a minimum income. Thus the company gets paid for limiting its ability to take advance of a favourable movement if the interest rate falls below the floor rate the company does not benefit therefore the counterparty does.

• It involves a company arranging both a minimum and a maximum limit on its interest rates payments or receipts. It enables a company to convert a floating rate of interest into a semi-fixed rate of interest.

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