Interest Rate Collar

Hi all,

Question related to Schweser’s Practice Exam - Volume 1 - Exam 2 Afternoon - Question 45:

The question asks for the payoff on an interest rate collar - the answer key describes a long collar as being long the call and short a put. My understanding is that a collar is being long the put and the premium is subsidized via selling a call - is my understanding wrong?

Look at interest rate collars from the perspective of a borrower. If you are borrowing money at a floating rate and you are concerned that rates will increase, you’d buy an interest rate call option. If rates increase past your call strike price you are paid off. You’ve put a “cap” on the rate you’ll pay.

This cap is financed by selling a put option on interest rates. Of course if rates fall below the put you’ll be out money, but you’re also be paying less on your floating rate loan. If rates do in fact rise the put expires worthless and you keep the premium.

Buy the cap and sell the floor.

Commonly, the long position gains when the underlying increases in value and loses when the underlying decreases in value. Using that approach, a long position in a collar would gain when interest rates rise and lose when they fall; that suggests that you’re long the call and short the put.