I have a question I am reading CFA text and am going through the calculations of an interest rate collar. I understand that if you have a loan starting today and if you set up a collar today you will have X interest payments and X-1 cap/floor payments. Because the caps are paid in arrears. However when I just did a schweser problem they had the same amount of interest payments and cap/floor payments. I thought the only way that is possible is if you set up the cap/floor before the actual loan. But if the problem does not tell us that how are we supposed to know? This is confusing me… Anyone else run into this problem?
This is precisely why you enter an interest rate collar before the actual loan… A collar is a combination of a cap an a floor. Caps and floors are essantially bundles of interest rates calls and puts. If you consider the case of Interest rate calls and puts, remember how we find their present values in order to deduce them from the actual money borrowed (for interest calls) or add them to the actual amount loaned out (interest puts). The fact that you find their FV is precisely because you take them and pay them BEFORE the loan so that you can coincide the payments on the loan and the payments on the option/cap/floor since those pay in arrears…
… So if you set the interest rate collar on the day the loan is taken, there would be one payment left “unhedged”
i understant that… but in the cfa text they always make it very clear that we are setting up the collar on the same day as the loan. thus leaving one payment unhedged. my concern is that the schweser problems in the readings all assume we set up the cap/floor prior to the actual laon. so if the question does not state we set it up on the same day are we to assume that we set it up prior?