Finance

Interest rate collar

Interest rate collar

An option strategy that limits the range of possibility of positive or negative returns on an underlying asset is called a collar. It is used to hedge against possible losses. An interest rate risk management strategy that uses derivatives to hedge an investor’s exposure to risks due to interest rate fluctuations is known as an interest rate collar. It basically protects a borrower against rising interest rates. It agrees to limit the borrower’s exposure to fluctuations to a specified ceiling rate and floor rate.

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How does Interest Rate Collar work?

It is a group of options that involves holding the underlying asset and buying a protective put while simultaneously selling a covered call against the holding. The payment for purchasing the put is paid from the premium received from writing the call. The call caps the upside potential for an increase in underlying assets price but protects the hedger from downward movements in the price. It includes the simultaneous purchase of an interest rate cap and the sale of an interest rate floor on the same index with the same maturity and principal amount.

Example

Advantages & Risk Involved

  1. The term of the collar is adjustable and can be customized as per the term of security of the underlying asset.
  2. An investor can set the cap and floor rates to reduce its overall premium or amount to zero.
  3. The borrower benefits from a pre-defined maximum rate of interest.

Risks:

  1. In case of a decline in interest rate from floor rate, the borrower misses out on a potential reduction in the cost of funds.
  2. The cost advantages over the interest floor rate may or may not compensate for potential losses.
  3. If the rates do not rise or decrease to the cap or floor level, the investor does not benefit from this floor.

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Bottom Line:

Interest rates collar is a low-risk management strategy that protects the borrower from downward falling prices due to interest rate fluctuations. This collar is a band between which an investor’s interest rate fluctuates. The interest expense will be limited and will therefore float between floor and cap. It ensures that the investor does not pay anything extra than the pre-determined level of interest.

 Author: Urvi Surti

About the Author:

Urvi is a commerce graduate and has a keen interest in Finance. She has completed her Chartered Wealth Management (CWM) from the American Academy of Financial Management and is currently pursuing a career in Financial Risk Management (FRM).

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