Interest rate collar
Summary
An interest rate collar is an option used to hedge exposure to interest rate moves. It protects a borrower against rising rates and establishes a floor on declining rates through the purchase of an interest rate cap and the simultaneous sale of an interest rate floor.What is an interest rate collar?
An interest rate collar is an option used to hedge exposure to interest rate moves. It protects a borrower against rising rates and establishes a floor on declining rates through the purchase of an interest rate cap and the simultaneous sale of an interest rate floor. Typically, the premium of the cap is designed to exactly match that of the floor to result in a zero cost collar.
Objective
A borrower who enters into a zero cost collar establishes the maximum interest rate payable (cap strike rate) at the cost of agreeing to pay a known minimum rate (floor strike rate). Between those two levels, the cost of finance will remain on a floating rate basis over the agreed period of time.
How does it work?
On each reset date, if the floating rate is equal to or below the cap strike rate, while simultaneously being equal to or above the floor strike rate, the bank will not make a payment to the borrower. If the floating rate is above the cap strike, the bank will pay the borrower the difference for the period. If the floating rate is below the floor strike, the borrower will pay the bank the difference.
Three scenarios of where the floating rate could settle and what the borrower will need to pay.
Advantages
- The borrower benefits from a pre-agreed maximum rate of interest
- The borrower has the flexibility to benefit from low floating rates down to the minimum floor level
- Unlike a cap, a collar can be structured such that there is no upfront premium cost
Disadvantages
- On early termination, if the borrower has to buy back the floor they may incur additional costs - however, they will be entitled to receive any residual value attributable to the cap
- If the floating rate fails to rise above the cap strike rate and/or remains below the floor strike rate during the tenor of the collar, the borrower may feel they received no value
An example of what an interest rate collar trade could look like.
Interest rate collar graph showing three potential outcomes over time.
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Disclaimers
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.
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