What are Interest rate collars used for? The collar is Long cap + short floor. Meaning its a portfolio of libor calls and puts? Wouldn’t that cancel everything out and everything would equal 0?
No I guess are locked for the payment you received and payment you make. You have to pay the difference.
edit: i hope mwvt9 has no prob with me posting this… it was my question and he answered. Re: Short a Floating Rate Bond? Posted by: mwvt9 (IP Logged) [hide posts from this user] Date: May 27, 2008 08:56AM barthezz Wrote: ------------------------------------------------------- > assume i have issued floating and want to limit my > interest cost with an interest rate collar. > > i am short floating rate bond. If you are short the floating rate bond then you lose if rates go up becaues you are paying the coupon. > > interest rate collar consists of: > short floor and long cap. > > so if rate increase the cap provides a hedge… > sets a maximum. > > if rates decrease (CFA, book 6, page 309): the > sale of the floor sets a minimum. What? the floor > is in the money if the reference rate is below the > floor rate. if i’m short i have to pay the long > the difference. > > the problem is why not long floor and short floor? We aren’t talking about a collar here just a floor. The floor is valuable to the long when interest rates drop, but that wouldn’t hedge our short bond because when rates drop we win. If we are short the floor then we get a premium and if intrest rates rise we will pocket the premium but that is all.
So a collar is basically long interest rates. You would gain the price you received from selling the floor if you shorted the floor (sell a put) plus the long cap value.
Collar could be long a cap and short a floor… or short a cap and long a floor… it depends what your goal in hedging is… If you have a LIBOR based liability (meaning you owe a floating rate), you would purchase a cap and sell a floor to keep your borrowing costs within a range…borrowing rate stays within a “collar”… If you have a LIBOR based asset (recieve floating), you would sell and cap and purchase a floor to keep your reciepts within a range…returns stay within a “collar”
Another good way to think about is in of a collar using stock options. If you sell an out of the money call, and buy an out of the money put, you have created a collar. You take the proceeds from the shorting the call, and buy a put for downside protection. In a sense, you are selling away your upside, to buy protection on the downside.
I remember it depends on what kinds of collar you have. You can lock in a rate if you are bond holder. Ex, buy 6% floor and sell 12 % cap. You can lock in your rate within 6 and 12. If you sold bond, you do reverse. I like Chadtap’s explanation.