Recall that we have 2 types of interest rates collars
long cap, short floor
long floor, short cap
Say if we have a LIBOR-based liability, I understand that longing cap will put a maximum on the liability we have based on the LIBOR rate. However, I don’t understand why we would be shorting a floor to put a minimum on the interest expense other than that we want to have a zero-cost collar at inception. This incentive doesnt convince me enough to putting a minimum on my expense.
Any comments are welcome!
The purpose of selling one option is to finance the purchase of the other option.
Even if its a not a zero cost collar, it will reduce our expense. ( expense = purchasing the long call, financed by shorting the put )
Agree. The reason for using a collar is probably just reducing expenses on the cap. Even though a floor limit the potential of benefiting from a large reduce in interest rate, as far as I believe, investors and firms prefer a certainty at low or no cost. Certainty is what management wants the most. Of course, they have a choice of not selling the put for a potential gain. We have 2 options, and the choice is based on risk appetite of the investor in question.
Interest Rate Collar is created by
We go Long Interest Rate Cap(Series of Interest rate Call options) - This way when Interest rates go up we will pay fixed and receive floating. So If we have a floating rate liability we will be able to finance that liability from payoffs of this cap (we are afraid that Interest rates go up).
We also go Short Interest Rate Floor ( Series of Interest Rate Put option) - Here we sell the floor wherein we pay fixed and recive floating. The buyer of the floor would exercise the option if Interest rates go down so that he receives fixed rate and pays lower market interest rate. We would suffer losses if Market Interest rates go down. However if Interest rate goes up, the long floor would not exercise and our payoff would be the premium for writing the Floor.
Assuming Interest rates go up we are hedged for our floating rate liability and the premium paid for our Interest Rate cap is reimbursed by Short Floor premium received.
If Interest rates go down, (We benefit by paying less on our floating rate liability + We have received premium for writing the floor) but also pay the losses on Short Floor(Pay fixed, Receive floating). Thus overall we are hedged again.
The same strategy in reverse applies for going Long Interest Rate floor and Short Interest rate cap (to finance our Floating Rate Asset)